We have recently shown that vagal denervation performed in the intrathoracic region in newborn lambs leads to hypoxemia and decreased respiratory system compliance which could result from atelectasis and/or pulmonary edema. Our previous study showed that denervated animals had reduced breathing rates, decreased frequency of augmented breaths and low dynamic functional residual capacity suggesting progressive loss of lung volume. However, pulmonary edema formation could not be ruled out as one of the potentially important mechanisms of decreased respiratory system compliance and hypoxemia. The objective of the current study was to quantify the relative roles of atelectasis and pulmonary edema as the mechanism (s) for respiratory failure. Vagal denervation was performed in the intrathoracic region and below the recurrent laryngeal nerves in six newborn lambs within 24 hours of birth, whereas six were sham operated. Pre- and post-inflation respiratory system compliance was measured to investigate the presence of atelectasis. Pulmonary edema was assessed using lung wet-dry/wet and lung tissue wet/dry ratios, total protein and fluorescein isothiocyanate bovine serum albumin (FITC-BSA) recovery in lung tissue and bronchoalveolar lavage. Respiratory system compliance was significantly lower in vagally denervated animals as compared with the sham operated group. However, post-inflation, pulmonary system compliance obtained by quasistatic lung inflation and deflation to 30 cmH₂O showed no significant difference between the sham and denervated lambs. The lung wet-dry/wet and lung tissue wet/dry ratios, total protein and FITC-BSA recovery in lung tissue and bronchoalveolar lavage were similar in denervated and sham operated groups. We provide evidence that reduced lung volume and not pulmonary edema is associated with intrathoracic vagal denervation and is the likely underlying mechanisms for hypoxemia and low respiratory system compliance.