In mouse embryos lacking sonic hedgehog (Shh), dorsoventral polarity within the otic vesicle is disrupted. Consequently, ventral otic derivatives, including the cochlear duct and saccule, fail to form, and dorsal otic derivatives, including the semicircular canals, endolymphatic duct and utricle, are malformed or absent. Since inner ear patterning and morphogenesis are heavily dependent on extracellular signals derived from tissues that are also compromised by the loss of Shh, the extent to which Shh signaling acts directly on the inner ear for its development is unclear. To address this question, we generated embryos in which smoothened (Smo), an essential transducer of Hedgehog (Hh) signaling, was conditionally inactivated in the otic epithelium (Smo^ecko). Ventral otic derivatives failed to form in Smo^ecko embryos, whereas vestibular structures developed properly. Consistent with these findings, we demonstrate that ventral, but not dorsal, otic identity is directly dependent on Hh. The role of Hh in cochlear-vestibular ganglion (cvg) formation is more complex, as both direct and indirect signaling mechanisms are implicated. Our data suggest that the loss of cvg neurons in Shh^–/– animals is due, in part, to an increase in Wnt responsiveness in the otic vesicle, resulting in the ectopic expression of Tbx1 in the neurogenic domain and subsequent repression of Ngn1 transcription. A mitogenic role for Shh in cvg progenitor proliferation was also revealed in our analysis of Smo^ecko embryos. Taken together, these data contribute to a better understanding of the intrinsic and extrinsic signaling properties of Shh during inner ear development.