Bronchopulmonary dysplasia is a chronic lung disease of extreme preterm infants and results in impaired gas exchange. Although bronchopulmonary dysplasia is characterized histologically by alveolar-capillary simplification in animal models, it is clinically defined by impaired gas diffusion. With the use of a developmentally relevant model, we correlated alveolar-capillary structural simplification with reduced functional gas exchange as measured by the diffusing factor for carbon monoxide (DF_CO). Neonatal mouse pups were exposed to >90% hyperoxia or room air during postnatal days 0 to 7, and then all pups were returned to room air from days 7 to 56. At day 56, DF_CO was measured as the ratio of carbon monoxide uptake to neon dilution, and lungs were fixed for histologic assessment of alveolar-capillary development. Neonatal hyperoxia exposure inhibited alveolar-capillary septal development as evidenced by significantly increased mean linear intercept, increased airspace-to-septal ratio, decreased nodal density, and decreased pulmonary microvasculature. Importantly, alveolar-capillary structural deficits in hyperoxia-exposed pups were accompanied by a significant 28% decrease in DF_CO (0.555 versus 0.400; P < 0.0001). In addition, DF_CO was highly and significantly correlated with structural measures of reduced alveolar-capillary growth. Simplification of alveolar-capillary structure is highly correlated with impaired gas exchange function. Current mechanistic and therapeutic animal models of inhibited alveolar development may benefit from application of DF_CO as an alternative physiologic indicator of alveolar-capillary development.