Fstl1, a secreted protein of the BMP antagonist class, has been implicated in the regulation of lung development and alveolar maturation. Here we generated a Fstl1-lacZ reporter mouse line as well as a Fstl1 knockout allele. We localized Fstl1 transcript in lung smooth muscle cells and identified Fstl1 as essential regulator of lung smooth muscle formation. Deletion of Fstl1 in mice led to postnatal death as a result of respiratory failure due to multiple defects in lung development. Analysis of the mutant phenotype showed impaired airway smooth muscle (SM) manifested as smaller SM line in trachea and discontinued SM surrounding bronchi, which were associated with decreased transcriptional factors myocardin/serum response factor (SRF) and impaired differentiation of SM cells. Fstl1 knockout mice also displayed abnormal vasculature SM manifested as hyperplasia SM in pulmonary artery. This study indicates a pivotal role for Fstl1 in early stage of lung airway smooth muscle development.