Epithelial-mesenchymal interactions during lung development require extracellular signaling factors that facilitate branching morphogenesis. We show here that matrix metalloproteinases (MMPs) originating in the mesenchyme are necessary for epithelial branching and alveolization. We found that the delayed lung maturation characterized by abnormal branching and poor alveolization seen in mice deficient in epidermal growth factor receptor(Egfr^-/-) is accompanied by aberrant expression of MMPs. By in situ zymography, the lungs from newborn Egfr^-/- mice had low gelatinolytic activity compared with wildtype. Inhibition of MMPs in developing lungs in vivo or in vitro severely retarded morphogenesis. Egfr^-/- mice had low expression of MT1-MMP/MMP14, which is a potent activator of gelatinase A/MMP2, in their lungs. Egf ligand increased MT1-MMP mRNA by tenfold in lung fibroblasts from wild type, but not from Egfr^-/- mice. Extracts from lungs of Egfr^-/- mice showed a tenfold reduction in active MMP-2, but only a slight decrease in proMMP-2 by zymography. At birth, MMP-2^-/- mice had a lung phenotype characterized by abnormal lung alveolization which phenocopied that of Egfr^-/- mice, albeit somewhat less severe. We conclude that proteolysis mediates epithelial/mesenchymal interactions during lung morphogenesis. From the phenotypes of the Egfr^-/- mice, we identify MT1-MMP as a major downstream target of Egfr signaling in lung in vivo and in vitro. MT1-MMP is, in turn, necessary for activation of MMP-2, a mesenchymal enzyme that is required for normal lung morphogenesis.