It basically cuts the loading time on the game etc...
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When the Xbox says install game it does not mean you are about to install the full game onto your hard drive. When you install a game on to your Xbox it's taking some of the game files and installing them to make the game run smoother and possibly look better.
It's quieter AND uses a crap load of space.
No, you can not a hard drive is required for add-ons. Because most game expansion are pretty big an xbox 360 memory unit will not hold them maybe it was some thing under about 100 mega bytes (and you have an xbox 360 memory unit) you could but if you dont you're outta luck.
In the hardrive in the console.
that happened to me it is something wrong with your hardrive