We develop a framework for studying trade in vertically and horizontally differentiated products. In our model, consumers with heterogeneous incomes and tastes purchase a homogeneous good as well as making a discrete choice of quality and variety of a differentiated product. The distribution of preferences in the population generates a nested logit demand structure. These demands are such that the fraction of consumers who buy a higher-quality product rises with income. We use the model to study the pattern of trade between countries that differ in size and income distributions but are otherwise identical. Trade―which is driven primarily by demand factors―derives from "home market effects" in the presence of transport costs. The model helps to explain why richer countries export higher-quality goods. It provides a tractable tool for studying the welfare consequences of trade, transport costs, and trade policy for different income groups in an economy.

We propose an equilibrium model that can explain a wide range of international finance puzzles, including the high correlation of international stock markets, despite the lack of correlation of fundamentals. We conduct an empirical analysis of our model, which combines cross-country-correlated long-run risk with Epstein and Zin preferences, using U.S. and U.K. data, and show that it successfully reconciles international prices and quantities, thereby solving the international equity premium puzzle. These results provide evidence suggesting a link between common long-run growth perspectives and exchange rate movements.