Like any other literacy, music literacy refers to how well you can read and write in this medium. Formal music education in common practice traditions tend to focus on music literacy; many other traditions focus instead on ear training but may include written forms as practice aids. How useful music literacy is to you will depend on what you want to do. For example, if you want to play Western classical music, literacy will be necessary. If you want to play popular music it would be useful but maybe not necessary. If you want to play folk music, literacy may not even be particularly useful.
Common notation is the most widely used way to write down music. However, there are many other kinds of music notation and "shorthand"-type ways to write down music that you may find useful. Some (for example, figured bass) are most useful within particular music traditions, while others (for example, tablature) are most useful when playing particular instruments. (See How to Read Music if you are not certain what kind of music-reading to pursue.)
If you have tried at all to follow written forms of music, you may be more literate than you realize. For example, If you cannot read a D seventh chord written in common notation, but you know what to play when you see "D7" written above a staff, that is a kind of music literacy. If you learned long ago how to read music notation but have not practiced since then, you may still know a lot of useful information (for example, what a note or rest looks like).
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