Bone morphogenetic protein 4 (Bmp4) is essential for lung development. To define the intracellular signaling mechanisms by which Bmp4 regulates lung development, BMP-specific Smad1 or Smad5 was selectively knocked out in fetal mouse lung epithelial cells. Abrogation of lung epithelial-specific Smad1, but not Smad5, resulted in retardation of lung branching morphogenesis and reduced sacculation, accompanied by altered distal lung epithelial cell proliferation and differentiation and, consequently, severe neonatal respiratory failure. By combining cDNA microarray with ChIP-chip analyses, Wnt inhibitory factor 1 (Wif1) was identified as a novel target gene of Smad1 in the developing mouse lung epithelial cells. Loss of Smad1 transcriptional activation of Wif1 was associated with reduced Wif1 expression and increased Wnt/β-catenin signaling activity in lung epithelia, resulting in specific fetal lung abnormalities. This suggests a novel regulatory loop of Bmp4-Smad1-Wif1-Wnt/β-catenin in coordinating BMP and Wnt pathways to control fetal lung development.