Sonic hedgehog (Shh) was conditionally deleted in respiratory epithelial cells of the embryonic lung in vivo. Deletion of Shh before embryonic day (E) 13.5 resulted in respiratory failure at birth. While lobulation was not perturbed, the lungs were hypoplastic, with reduced branching of peripheral lung tubules, evident from E13.5. Smooth muscle and endothelial cells were absent or reduced, the latter in relationship to the loss of peripheral lung parenchyma. Tracheal-bronchial ring abnormalities occurred when Shh was deleted between E8.5 and E12.5. Deletion of Shh later in gestation (after E13.5) caused mild abrogation of peripheral branching morphogenesis but did not disrupt tracheal-bronchial development. Defects in branching morphogenesis and vascularization seen in Shh null mutant (Shh(-/-)) mice were substantially corrected when SHH was ectopically expressed in the respiratory epithelium; however, peripheral expression of SHH failed to correct cartilage abnormalities in the trachea and bronchi, indicating a spatial requirement for SHH expression near sites of cartilage formation. Expression of SHH by the respiratory epithelium plays an important role in the patterning of tracheal-bronchial mesenchyme required for formation of cartilage rings in conducting airways. SHH regulates branching morphogenesis and influences differentiation of the peripheral lung mesenchyme required for formation of bronchial and vascular smooth muscle.