Lets say you have sequenced an application which created a file under C:\Test\App\123.txt. There are some other files[Lets say 456.txt & 789.txt] in the same directory on a machine where you have published the application. There will be some cases where your virtualized application may need to read information from the files/registries which are part of your local OS[which means not virtualized].
If you set the Directory App as Merge with Local then your AppV Client will be able to read the information[if required] from all the files in that Directory though the files 456.txt & 789.txt are not part of your virtualized package.
If you set the Directory App as Override Local then your AppV Client will not be able to get the information from any other files in that folder other than the file that your application has created. In the above case AppV Client will only be able to read information from 123.txt.
By default, while sequencing if a new folder gets created then that will be marked as Override Local. If files get copied to a folder which already exists then that will be marked as Merge with Local.
LOCAL_INTERACTION_ALLOWED is kind of configuration by which you can let your virtualized application interact with the OS. This is required for some virtualized applications to function properly. The values can either be TRUE - Interact or FALSE - Don't Interact.
My personal opinion is that LOCAL_INTERACTION_ALLOWED & Override/Merge does not relate to each other.
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