The vasculature forms an intrinsic functional component of the lung and its development must be tightly regulated and coordinated with lung epithelial morphogenesis. Vascular endothelial growth factor (VEGF) and its receptors are highly expressed in a complementary pattern in the lungs during embryonic development. VEGF is expressed by epithelium and the receptors in the surrounding mesenchyme. To determine the function of VEGF in lung formation, we inhibited its activity using a soluble receptor in lung renal capsule grafts. Inhibition of VEGF results in inhibition of vascular development and significant alteration in epithelial development. Epithelial proliferation is inhibited, sacculation is impaired, and the epithelium undergoes apoptosis. Interestingly, when VEGF is attenuated, epithelial differentiation still proceeds, as shown by acquisition of both proximal and distal markers. These data show that VEGF co-ordinates epithelial and vascular development. It is required for the development of the lung vasculature and the vasculature is necessary for epithelial proliferation and morphogenesis, but not for cell differentiation.