Little is known about how retinoic acid (RA) synthesis, utilization and metabolism are regulated in the embryonic lung and how these activities relate to lung pattern formation. Here we report that early lung bud formation and subsequent branching morphogenesis are characterized by distinct stages of RA signaling. At the onset of lung development RA signaling is ubiquitously activated in primary buds, as shown by expression of the major RA-synthesizing enzyme, RALDH-2 and activation of a RARE-lacZ transgene. Nevertheless, further airway branching appears to require downregulation of RA pathways by decreased synthesis, increased RA degradation in the epithelium via P450RAI-mediated metabolism, and inhibition of RA signaling in the mesenchyme by COUPTF-II expression. These mechanisms controlling local RA signaling may be critical for normal branching, since we show that manipulating RA levels in vitro to maintain RA signaling activated as in the initial stage, leads to an immature lung phenotype characterized by failure to form typical distal buds. We show that this phenotype likely results from RA interfering with the establishment of a distal signaling center, altering levels and distribution of Fgf10 and Bmp4, genes that are essential for distal lung formation. Furthermore, RA upregulates P450RAI expression, suggesting the presence of feedback mechanisms controlling RA availability. Our study illustrates the importance of regional mechanisms that control RA availability and utilization for correct expression of pattern regulators and normal morphogenesis during lung development.