Sonic hedgehog (Shh) signaling plays a critical role in hair follicle development and skin cancer, but how it controls these processes remains unclear. Of the three Gli transcription factors involved in transducing Shh signals in vertebrates, we demonstrate here that Gli2 is the key mediator of Shh responses in skin. Similar toShh ^−/− mice, Gli2 ^−/− mutants exhibit an arrest in hair follicle development with reduced cell proliferation and Shh-responsive gene expression, but grossly normal epidermal differentiation. By transgenic rescue experiments, we show that epidermal Gli2 function alone is sufficient to restore hair follicle development in Gli2 ^−/− skin. Furthermore, only a constitutively active form of Gli2, but not wild-type Gli2, can activate Shh-responsive gene expression and promote cell proliferation in Shh ^−/− skin. These observations indicate that Shh-dependent Gli2 activator function in the epidermis is essential for hair follicle development. Our data also reveal that Gli2 mediates the mitogenic effects of Shh by transcriptional activation of cyclin D1 and cyclin D2 in the developing hair follicles. Together, our results suggest that Shh-dependent Gli2 activation plays a critical role in epithelial homeostasis by promoting proliferation through the transcriptional control of cell cycle regulators.