Interactive debugging with Dagster and Docker is made possible by leveraging the `debugpy` library to set up a remote debugging session in the code location container, while utilizing Docker Compose to orchestrate the containers. This setup allows for seamless debugging of assets, schedules, and other code within the containerized environment. The debug configuration in VSCode enables connection to the remote debugger running in the code location container, facilitating step-by-step debugging of the code. By using this approach, developers can ensure a smoother development experience and quickly find and fix bugs, making it an essential tool for software and data engineering.