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In the magical world created within the Harry Potter books written by J.K. Rowling, a muggle is an individual who does not have magical powers. The majority of the world is inhabited by muggles, who go about living their daily lives utterly oblivious to the wizarding world which is actually all around them. While readers might be tempted to think of muggles as second class citizens, Rowling is careful to portray them as ordinary human beings who run the gamut from perfectly nice well meaning individuals to nasty families like the Dursleys.
The term “muggle” was actually used in popular culture before Rowling's books were released. Starting in the 1920s, it was a slang term for marijuana, and it also appeared with various meanings in several children's books. After the release of the Harry Potter series, several groups adopted to the term to refer to people outside their group: Pagans, for example, may call non-Pagans muggles. The Oxford English Dictionary has also picked up the term, using it to refer to individuals who are clumsy or unable to acquire a new skill.
The Harry Potter series opens with the young hero's life with the Dursleys, the foster family which has cared for him since the mysterious death of his parents at the age of one. Although he is a wizard, Harry has grown up in the muggle world, and is unaware of the world of magic that his parents inhabited. When he turns 11, Harry is informed that he is, in fact, a wizard, and entitled to attend Hogwarts School of Witchcraft and Wizardry. Harry is whirled away on a magical adventure, although still forced to endure his dull muggle family on holidays.
According to Rowling, a wizard can be born into a muggle family, and in fact one of the main characters in the books, Hermione Granger, is muggle-born. Some wizards who come from families that have practiced wizardry for centuries look down on muggle born wizards, calling them “mudbloods,” in a reference to their impure origins. This term is considered highly offensive by most of the wizarding community, which views muggle borns as being on an equal status with regular wizards.
More rarely, a non-magic individual will be born into a wizarding family. In this case, the individual is known as a squib. Squibs live a strange half-life, because they are connected to the wizarding world by birth, but are not actually wizards themselves. Many squibs are also not entirely muggles: they can see more magical acts than muggles can, for example. Most continue to live and work in the wizarding world, like Argus Filch, the Caretaker at Hogwarts. Others apparently pursue lives in the muggle world, because they feel too disconnected from their wizarding kin.
In some cases, wizards fall in love with muggles and marry them. The resulting children are called half bloods, in a nod to their mixed ancestry. Like muggle-borns, half bloods are welcomed by the majority of the wizarding community, although some pure-blood elitists disapprove of this.
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Actually, the word "muggle" seems to go back to the History of Britain of Laghamon (on Google books as "Layamon's Brut" -- see pages 185/186 of Book 3)where "muggles" (or moggles) are tails, and people with tails are called "mugglings" -- the story goes that the people of Dorchester (or possibly Rochester) dishonored a Saint Austin by attacing fish tails to his cloak, whereupon he cursed them with having tails.
I saw this in a book called "The Lion's Tail" published in about 1970. Given J K Rowling's interest in the past, this could i imagine have been her source for the name -- it seems just as likely as saying that she picked up 1920's slang for a spliff, anyway.