Further to post #2683 above, here are two more examples of the use of "living world". The first recommends a significant amount of prep while the second advocates 'Schrodinger's GM-ing' – abandoning one's prep!
Dragon #65 (1982), Law of the land by Ed Greenwood
In the article “Plan Before You Play” (DRAGON™ issue #63), we looked at politics on a large scale… But more important in AD&D play is the to-and-fro of local human interaction, the politics of everyday life in a village or a kingdom…
Development of local politics will give any campaign depth and believability, and at the same time create reasons and impetus for characters to undertake adventures (and players to role-play). Make a world seem real, so that what occurs matters to the players, and you will make play far more enjoyable and memorable — and a DM owes it to his or her players to give them an active, living world to engage their interest, rather than a colorful background of artificial, lifeless immobility through which characters are allowed to rampage.
Dragon #184 (1992), “You again!” by Scott Sheffield
During the course of play, PCs invariably suffer various misfortunes. Given time, players might attribute their unfortunate circumstances to the fiendish machinations of their slippery NPC foes. Sometimes their suppositions may indeed be correct, while at other times they may be wildly inaccurate. If a player incorrectly concludes that the party’s nemesis is behind the PCs’ misfortunes, you as the DM shouldn’t disabuse the player of the notion. Instead, permit the players to draw their own conclusions, and have fun.
If the players’ inferences are erroneous but nevertheless intriguing, a nimble DM can modify the story line in that direction. Done well, this enriches play as players start to see the adventuring environment as a living world where happenings are not a collection of random encounters without meaning or connection.