The mammalian lung, like many other organs, develops by branching morphogenesis of an epithelium [1]. Development initiates with evagination of two ventral buds of foregut endoderm into the underlying splanchnic mesoderm. As the buds extend, they send out lateral branches at precise, invariant positions, establishing the primary airways and the lobes of each lung. Dichotomous branching leads to further extension of the airways. Grafting studies have demonstrated the importance of bronchial mesenchyme in inducing epithelial branching, but the significance of epithelial signaling has largely been unstudied. The morphogen Sonic hedgehog (Shh) is widely expressed in the foregut endoderm and is specifically upregulated in the distal epithelium of the lung where branching is occurring [2]. Ectopic expression of Shh disrupts branching and increases proliferation, suggesting that local Shh signaling regulates lung development [2]. We report here that Shh is essential for development of the respiratory system. In Shh null mutants, we found that the trachea and esophagus do not separate properly and the lungs form a rudimentary sac due to failure of branching and growth after formation of the primary lung buds. Interestingly, normal proximo-distal differentiation of the airway epithelium occurred, indicating that Shh is not needed for differentiation events. In addition, the transcription of several mesenchymally expressed downstream targets of Shh is abolished. These results highlight the importance of epithelially derived Shh in regulating branching morphogenesis of the lung.