Branching morphogenesis of the embryonic lung requires interactions between the epithelium and the mesenchyme. Previously, we reported that Sonic hedgehog (Shh) transcripts are present in the epithelium of the developing mouse lung, with highest levels in the terminal buds. Here, we report that transcripts of mouse patched (Ptc), the homologue of a Drosophila gene encoding a putative transmembrane protein required for hedgehog signaling, are expressed at high levels in the mesenchyme adjacent to the end buds. To investigate the function of SHH in lung development, Shh was overexpressed throughout the distal epithelium, using the surfactant protein-C (SP-C)-enhancer/promoter. Beginning around 16.5 dpc, when Shh and Ptc RNA levels are normally both declining, this treatment caused an increase in the ratio of interstitial mesenchyme to epithelial tubules in transgenic compared to normal lungs. Transgenic newborn mice die soon after birth. Histological analysis of the lungs at the light and electron microscope level shows an abundance of mesenchyme and the absence of typical alveoli. In vivo BrdU labeling indicates that Shh overexpression results in increased mesenchymal and epithelial cell proliferation at 16.5 and 17.5 dpc. However, analysis of CC-10 and SP-C expression reveals no significant inhibition in the differentiation of proximal and distal epithelial cells. The expression of genes potentially regulated by SHH was also examined. No difference could be observed between transgenic and control lungs in either the level or distribution of Bmp4, Wnt2 and Fgf7 RNA. By contrast, Ptc is clearly upregulated in the transgenic lung. These results thus establish a role for SHH in lung morphogenesis, and suggest that SHH normally regulates lung mesenchymal cell proliferation in vivo.