Transforming growth factor-beta (TGF-) mediates hypoxia-induced inhibition of alveolar development in the newborn lung. TGF- is regulated primarily at the level of activation of latent TGF-. Fibroblasts expressing Thy-1 (CD90) inhibit TGF- activation. We hypothesized that loss of Thy-1 due to hypoxia may be a mechanism by which hypoxia increases TGF- activation, and that animals deficient in Thy-1 will simulate the effects of hypoxia on lung development. To determine if loss of Thy-1 occurred during hypoxia, non-transgenic (C57BL/6) wild-type (WT) mice exposed to hypoxia were evaluated for Thy-1 mRNA and protein. To determine if Thy-1 deficiency simulated hypoxia, WT and Thy-1 null (Thy-1^-/-) mice were exposed to air or hypoxia from birth to two weeks, the critical period of lung development, and lung histology, function, parameters related to TGF- signaling, and extracellular matrix protein content were measured. To test if the phenotype in Thy-1^-/- mice was due to excessive TGF- signaling, measurements were also performed in Thy-1^-/- mice administered TGF- neutralizing antibody (1D11). We observed that hypoxia reduced Thy-1 mRNA and Thy-1 staining in WT mice. Thy-1^-/- mice had impaired alveolarization, increased TGF- signaling, reduced lung epithelial and endothelial cell proliferation but increased fibroblast proliferation, and increased collagen and elastin. Lung compliance was lower, and tissue but not airway resistance was higher in Thy-1^-/- mice at 2 weeks. Thy-1^-/- mice given 1D11 had improved alveolar development and lung function. These data support the hypothesis that hypoxia, by reducing Thy-1, increases TGF- activation, and thereby inhibits normal alveolar development.