Ironically, I feel asleep writing the entry on dreams. My computer battery then died and I was left without a means of easy typing all weekend (these entries are a bitch to do on a cell phone keyboard). So, I will be doing some catch up entries this week.
Dreams are one of those freakish biological phenomena of which we have almost no more understanding now than we did 2000 years ago. We kind of get the where and the when but the how and the why still have not been provided by science. As such, this is one of the areas of knowledge deficit that is currently impossible to overcome. If Shapeshifters or the middle east are mysteries that can generate horror, then dreams certainly can.
In horror stories, dreams are often ways of relaying information the protagonist would not ordinarily receive. Perhaps a dead relative is coming to give advice or a ghostly figure just points somewhere you need to look. Plot advancement is a handy trick for dreams because you really don't have to explain how they are working. Your guess is literally as good as mine.
In horror movies, dreams almost always represent a fake out. If you see the plot resolved or the protagonist die waaaaay too early in a movie's runtime, you can almost be assured that most recent plot development was part of a dream. Dreams are also great for flash forwards and flashbacks. But do dreams serve any narrative purpose beyond exposition, time killing and fake out scares?
I believe, in a broader sense, they do. To include a dream sequence in your story is to announce that the world of the film might not operate by waking logic and rational behavior. Dreams can get even more twisted and bizarre than any vampire or ghost story. In my favorite horror movie, The Innkeepers, there is a fake scare dream sequence that serves another narrative purpose besides a cheap thrill. One of the main tensions in the movie is the conflict between what is really happening and what is a product of the main character's imagination. That the hotel is supposed to be haunted by the ghost of a woman who died waiting for her fiance leads to a dream sequence where the protagonist sees the ghost of the woman in her bedroom. The fact that the woman is in a wedding dress and kind of looks like a scary video her friend showed her earlier seems to imply that this is the mental projection of what the main character thinks a ghost should look like. Therefore, towards the end of the film, when that same ghost makes a return appearance looking exactly the same, we are left to ask if this is still just a mental projection.
I would be remiss not the mention the Nightmare on Elm Street movies in this entry. Wes Craven really took the ball and ran with it in regards to people feeling vulnerable in their sleep. Freddy Krueger is evil incarnate and pretty much impossible to kill in the first film. Later movies would allow his would-be victims to learn dream fighting techniques but those movies also turned Freddy into a dark Bugs Bunny surrogate. That first flick is still pretty hardcore and taps directly into the idea that dreams can influence reality just as much as the other way around.
To take this even further is the very real phenomenon of night terrors (which I have suffered from). I have spoken about Sleep Paralysis before but, to me, Night Terrors are different. When I am suffering a night terror, I think I am awake and seeing something in front of me. Unlike sleep paralysis, I am anything but paralyzed. I often jump up, scream or start taking swings at the imaginary things in the room (which has led to at least one of my break-ups). This is that dangerous place where dreams meet reality, I can't tell the difference and I am in full control of my body. Spooks me out just thinking about it.