Sonic Hedgehog (Shh) signaling regulates mesenchymal proliferation and differentiation during embryonic lung development. In the adult lung, Shh signaling maintains mesenchymal quiescence and is dysregulated in diseases such as idiopathic pulmonary fibrosis and chronic obstructive pulmonary disease. Our previous data implicated a role for Shh in postnatal lung development. Here, we report a detailed analysis of Shh signaling during murine postnatal lung development. We show that Shh pathway expression and activity during alveolarization (postnatal day [P] 0-P14) are distinct from those during maturation (P14-P24). This biphasic pattern is paralleled by the transient presence of Gli1+;α-smooth muscle actin (α-SMA)+ myofibroblasts in the growing alveolar septal tips. Carefully timed inhibition of Hedgehog (Hh) signaling during alveolarization defined mechanisms by which Shh influences the mesenchymal compartment. First, interruption of Hh signaling at earlier time points results in increased lung compliance and wall structure defects of increasing severity, ranging from moderately enlarged alveolar airspaces to markedly enlarged airspaces and fewer secondary septa. Second, Shh signaling is required for myofibroblast differentiation: Hh inhibition during early alveolarization almost completely eliminates Gli1+;α-SMA+ cells at the septal tips, and Gli1-lineage tracing revealed that Gli1+ cells do not undergo apoptosis after Hh inhibition but remain in the alveolar septa and are unable to express α-SMA. Third, Shh signaling is vital to mesenchymal proliferation during alveolarization, as Hh inhibition decreased proliferation of Gli1+ cells and their progeny. Our study establishes Shh as a new alveolarization-promoting factor that might be affected in perinatal lung diseases that are associated with impaired alveolarization.