Homeobox genes have recently been demonstrated to be important for the proper patterning of the mammalian telencephalon. One of these genes is Gsh2, whose expression in the forebrain is restricted to the ventral domain. In this study, we demonstrate that Gsh2 is a downstream target of sonic hedgehog and that lack of Gsh2 results in profound defects in telencephalic development. Gsh2 mutants have a significant decrease in the expression of numerous genes that mark early development of the lateral ganglionic eminence, the striatal anlage. Accompanying this early loss of patterning genes is an initial expansion of dorsal telencephalic markers across the cortical-striatal boundary into the lateral ganglionic eminence. Interestingly, as development proceeds, there is compensation for this early loss of markers that is coincident with a molecular re-establishment of the cortical-striatal boundary. Despite this compensation, there is a defect in the development of distinct subpopulations of striatal neurons. Moreover, while our analysis suggests that the migration of the ventrally derived interneurons to the developing cerebral cortex is not significantly affected in Gsh2 mutants, there is a distinct delay in the appearance of GABAergic interneurons in the olfactory bulb. Taken together, our data support a model in which Gsh2, in response to sonic hedgehog signaling, plays a crucial role in multiple aspects of telencephalic development.