Epithelial-mesenchymal interactions and extracellular matrix remodeling are key processes of embryonic lung development. Lung smooth muscle cells, which are derived from the mesenchyme, form a sheath around bronchi and blood vessels. During lung organogenesis, smooth muscle differentiation coincides with epithelial branching morphogenesis and closely follows developing airways spatially and temporally. The precise function of parabronchial smooth muscle (PBSM) cells in healthy adult lung remains unclear. However, PBSM may regulate epithelial branching morphogenesis during lung development by the induction of mechanical stress or through regulation of paracrine signaling pathways. Alveolar myofibroblasts are interstitial contractile cells that share features and may share an origin with smooth muscle cells. Alveolar myofibroblasts are essential for secondary septation, a process critical for the development of the gas-exchange region of the lung. Dysregulation of PBSM or alveolar myofibroblast development is thought to underlie the pathogenesis of many lung diseases, including bronchopulmonary dysplasia, asthma, and interstitial fibrosis. We review the current understanding of the regulation of PBSM and alveolar myofibroblast development, and discuss the role of PBSM in lung development. We specifically focus on the role of these cells in the context of fibroblast growth factor-10, sonic hedgehog, bone morphogenetic protein-4, retinoic acid, and Wnt signaling pathways in the regulation of lung branching morphogenesis. Birth Defects Research (Part C) 78:80 -89, 2006.