Notch signaling regulates cell fate determination and many developmental processes. Here we report that lateral inhibition, a major mechanism for Notch activity, is modulated by Hairy, a bHLH-WRPW protein. In Xenopus, Notch can have from inhibitory, permissive to enhancing roles in muscle or neural differentiation. These cell context-dependent effects correlate with Hairy expression levels from high to low, respectively, in the cells. Moreover, Notch effects can be altered upon manipulation of Hairy expression. We propose that Hairy provides a cell context in which a cell can interpret Notch and other extrinsic signals by controlling responsiveness of its target genes; this mode of Hairy–Notch interaction may apply in other systems.