This page is presented in an out-of-character manner, since it deals with concepts that are important to the setting but which benefit from more of a high-level overview rather than trying to explain them in-character.
The world of Night Knights operates on three broad layers of reality.
There is the world as occupied by humans, their families, houses, pets, jobs, cars, schools, etc. For want of a better word, this is the “real world” and operates on broadly the same rules as our own.
There is the world as occupied by toys, where a child's playthings come to life when they're not being watched, live their own lives, generally care about their child, and interact with each other. In Night Knights, these are the toys owned by Jordan, an 8 year old child, and the scope of their world is limited to The House.
There is the world as occupied by monsters, where terrors lurk, ready to strike fear into the hearts of small children. They hide in the dark places, fear the light, and have their own agendas and societies.
Humans are not aware that toys are alive. Jordan may act as if the toys are alive, as part of their play, but this does not take the form of actual interaction between “Jordan as an NPC” and “the toys as PCs and NPCs”, and other human characters will treat this as just Jordan's active imagination (and remember their own toys through the same lens of “just imagination”). Within the scope of the game, there will always be at least a somewhat reasonable explanation on the “real world” layer for anything that goes on, even if that explanation is just Jordan playing with their toys and not clearing them up properly, things getting lost in the move, or the dog moving things around or breaking things.
Humans discovering or suspecting that toys are real is not within the scope of the game, nor is toys interacting directly with humans - during the daytime, rooms with a human in are out of the scope for turnsheet actions, and we'll make clear which rooms these are (on weekdays IC, this will usually only be the study where Jordan's dad is working). Similarly, if Jordan's fears cause them to wake up from a nightmare, that will put an end to actions in the room for the night (and is one of the failure states if your characters fail to defend against the monsters in a turnsheet).
Anything outside of the house and its garden is out of scope for turnsheet actions - there may be some limited ways to interact with this in response to certain plots (e.g. sneaking an item into Jordan's bag to take to school), but toys cannot go there.
The dog can interact with toys - they might set him off barking or chasing after them if they end up in the same room as him - but he's a new puppy so the list of things that can set him off barking or chasing around the room includes “absolutely nothing, he just does that”.
Out of character, it's equally reasonable to treat the story of the game as if it is Jordan processing their fears about moving into a new house and sleeping alone in their room through imaginative play, as it is to treat it as an actual story of living toys1). In character, your characters are the living toys, so the latter interpretation is clearly true from their perception.
The monsters lurk in the dark spaces of the house - underneath the bed, outside the window once the sun has gone down, in the closet, and in the attic.
These monsters terrify Jordan - they will wake up screaming in the night if the monsters are not held back by the valiant efforts of the toys. They will not cause any physical harm to Jordan - the stakes of the game are a child being traumatised by their nightmares and their fear of a new house and sleeping alone, rather than physical injury to that child.
They do not present an issue to the other humans in the house - though Jordan's sister overcame similar troubles in the past.
As with the toys, humans other than Jordan are not aware of the monsters, and they will be treated as part of Jordan's nightmares. As with the toys, out of character it is reasonable to treat these either as products of Jordan's imagination, or actual things that exist, but in character the toys will know that the monsters exist and are a problem.
Monsters are fully aware of the existence and actions of the toys (to within the usual limits of their perceptions). Toys are fully aware of the existence and actions of the monsters (to within the usual limits of their perceptions).
Other than in the attic (which is always dark and scary), the monsters will only appear at night. Their motivations and actions are left as something to discover in-game, but it is possible for them to attack or kill toys, or to drag them away never to be seen again. Toys can fight against monsters - how to do this is, again, left as something to discover in-game.