The ability to measure the effects of local alterations in blood flow, blood volume and oxygenation by nuclear magnetic resonance has stimulated a surge of activity in functional MRI of many organs, particularly in its application to cognitive neuroscience. However, the exact description of these effects in terms of the interrelations between the MRI signal changes and the basic physiological parameters has remained an elusive goal. We here present this fundamental theory for spin-echo signal changes in perfused tissue and validate it in vivo in the cat brain by using the physiological alteration of hypoxic hypoxia. These experiments show that high-resolution absolute blood volume images can be obtained by using hemoglobin as a natural intravascular contrast agent. The theory also correctly predicts the magnitude of spin-echo MRI signal intensity changes on brain activation and thereby provides a sound physiological basis for these types of studies.