The setting is Germany during the Napoleonic Wars. Mytyl (Shirley Temple), the bratty and ungrateful daughter of a woodcutter (Russell Hicks (actor)), finds a unique bird in the Royal Forest and selfishly refuses to give it to her sick friend. Mother (Spring Byington) and Father are mortified at Mytyl's behavior. That evening, Father is called on to report for military duty the next morning. That same night, Mytyl is visited in a dream by a fairy named Berylune (Jessie Ralph) who sends her and her brother Tyltyl (Johnny Russell) to search for the Blue Bird of Happiness. To accompany them, the fairy magically transforms their dog Tylo (Eddie Collins (actor)), cat Tylette (Gale Sondergaard), and lantern ("Light") into human form. The children have a number of adventures: they visit the past (meeting their dead grandparents who come to life because they are being remembered), have a scary adventure in the forest, experience the life of luxury, and see the future, a land of yet-to-be born children. The dream journey makes Mytyl awake as a kinder and gentler girl who has learned to appreciate all the comforts and joys of her home and family. In the morning, Father receives word that a truce has been called and he does not have to go to war.