Although retinoic acid (RA) has been implicated as one of the diffusible signals regulating forebrain development, patterning of the forebrain has not been analyzed in detail in knockout mouse mutants deficient in embryonic RA synthesis. We show that the retinaldehyde dehydrogenase 2 (RALDH2) enzyme is responsible for RA synthesis in the mouse craniofacial region and forebrain between the 8- and 15-somite stages. Raldh2-/- knockout embryos exhibit defective morphogenesis of various forebrain derivatives, including the ventral diencephalon, the optic and telencephalic vesicles. These defects are preceded by regionally decreased cell proliferation in the neuroepithelium, correlating with abnormally low D-cyclin gene expression. Increases in cell death also contribute to the morphological deficiencies at later stages. Molecular analyses reveal abnormally low levels of FGF signaling in the craniofacial region, and impaired sonic hedgehog signaling in the ventral diencephalon. Expression levels of several regulators of diencephalic, telencephalic and optic development therefore cannot be maintained. These results unveil crucial roles of RA during early mouse forebrain development, which may involve the regulation of the expansion of neural progenitor cells through a crosstalk with FGF and sonic hedgehog signaling pathways.