We have found that the ubiquitin-proteasome pathway exerts exquisite control of osteoblast differentiation and bone formation in vitro and in vivo in rodents. Structurally different inhibitors that bind to specific catalytic β subunits of the 20S proteasome stimulated bone formation in bone organ cultures in concentrations as low as 10 nM. When administered systemically to mice, the proteasome inhibitors epoxomicin and proteasome inhibitor-1 increased bone volume and bone formation rates over 70% after only 5 days of treatment. Since the ubiquitin-proteasome pathway has been shown to modulate expression of the Drosophila homologue of the bone morphogenetic protein-2 and -4 (BMP-2 and BMP-4) genes, we examined the effects of noggin, an endogenous inhibitor of BMP-2 and BMP-4 on bone formation stimulated by these compounds and found that it was abrogated. These compounds increased BMP-2 but not BMP-4 or BMP-6 mRNA expression in osteoblastic cells, suggesting that BMP-2 was responsible for the observed bone formation that was inhibited by noggin. We show proteasome inhibitors regulate BMP-2 gene expression at least in part through inhibiting the proteolytic processing of Gli3 protein. Our results suggest that the ubiquitin-proteasome machinery regulates osteoblast differentiation and bone formation and that inhibition of specific components of this system may be useful therapeutically in common diseases of bone loss.