"Nighty night" is slang for "Good night" and carries the same meaning, as is "G'night", an informal contraction. You may reply with any acceptable response, such as "you, too" or "good night." Because night is generally associated with sleeping, "good night" has two meanings; the first used as a farewell for leaving for the night (such as leaving a party or other late-night event), or for going to sleep. Nighty night is usually only appropriate as the second meaning of "good night", although that is culture specific, and is often said in that context when at least one of the members of that dialog are children.
This term has its origin long ago, before electricity could light the night easily, and most people slept at night, it became a common expression of goodwill and of temporary parting, particularly when one was going to sleep or going away for the night. It also likely has its roots in the fact that many people thought that dreams occurred in another world, and so were literally telling you to have a safe journey.
As times have changed, we spend more time awake at night, working many odd hours that are in contrast to what many call the "natural cycle" for humans. Regardless of this adaptation of society, this saying has been in use for such a long time that it is still used even in the event that the phrase is said early in the morning or even in the afternoon.
You would not say "Good morning," "Good afternoon," or "Good evening" to someone that is going to sleep during those time periods in the day, because those are all classified as "greetings," while "good night" is a "farewell." As many English phrases and Words go, it is incorrect to switch two Words or phrases that have completely different meaning even if they are contextually accurate.
If you said "good morning" to someone going to sleep at 9 o'clock in the morning, it would be the wrong meaning, because that is a greeting said in the morning, not a farewell. If you meant to tell the person that you wish them a pleasant dream, you could use "good night" or another similar phrase, such as "pleasant dreams", "sweet dreams", or "sleep well."
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