In vertebrates, Sonic hedgehog (Shh) and transforming growth factor-beta (TGF-beta) signaling pathways occur in an overlapping manner in many morphogenetic processes. In vitro data indicate that the two pathways may interact. Whether such interactions occur during embryonic development remains unknown. Using embryonic lung morphogenesis as a model, we generated transgenic mice in which exon 2 of the TbetaRII gene, which encodes the type II TGF-beta receptor, was deleted via a mesodermal-specific Cre. Mesodermal-specific deletion of TbetaRII (TbetaRII(Delta/Delta)) resulted in embryonic lethality. The lungs showed abnormalities in both number and shape of cartilage in trachea and bronchi. In the lung parenchyma, where epithelial-mesenchymal interactions are critical for normal development, deletion of mesenchymal TbetaRII caused abnormalities in epithelial morphogenesis. Failure in normal epithelial branching morphogenesis in the TbetaRII(Delta/Delta) lungs caused cystic airway malformations. Interruption of the TbetaRII locus in the lung mesenchyme increased mRNA for Patched and Gli-1, two downstream targets of Shh signaling, without alterations in Shh ligand levels produced in the epithelium. Therefore, we conclude that TbetaRII-mediated signaling in the lung mesenchyme modulates transduction of Shh signaling that originates from the epithelium. To our knowledge, this is the first in vivo evidence for a reciprocal and novel mode of cross-communication between Shh and TGF-beta pathways during embryonic development.