The TGF-beta superfamily of growth and differentiation factors, including TGF-beta, Activins and bone morphogenetic proteins (BMPs) play critical roles in regulating the development of many organisms. These factors signal through a heteromeric complex of type I and II serine/threonine kinase receptors that phosphorylate members of the Smad family of transcription factors, thereby promoting their nuclear localization. Although components of TGF-beta/Activin signaling pathways are well defined in vertebrates, no such pathway has been clearly defined in invertebrates. In this study we describe the role of Baboon (Babo), a type I Activin receptor previously called Atr-I, in Drosophila development and characterize aspects of the Babo intracellular signal-transduction pathway. Genetic analysis of babo loss-of-function mutants and ectopic activation studies indicate that Babo signaling plays a role in regulating cell proliferation. In mammalian cells, activated Babo specifically stimulates Smad2-dependent pathways to induce TGF-beta/Activin-responsive promoters but not BMP-responsive elements. Furthermore, we identify a new Drosophila Smad, termed dSmad2, that is most closely related to vertebrate Smads 2 and 3. Activated Babo associates with dSmad2 but not Mad, phosphorylates the carboxy-terminal SSXS motif and induces heteromeric complex formation with Medea, the Drosophila Smad4 homolog. Our results define a novel Drosophila Activin/TGF-beta pathway that is analogous to its vertebrate counterpart and show that this pathway functions to promote cellular growth with minimal effects on patterning.