I don't think the entire game is purely a dream of the player's character. That's not a very satisfying conclusion to me, because so much of the game has nothing to do with the main character -- We don't learn anything about their past, and how their dream my be influenced by it, so the question of "why is this happening?" would have no answer and no relevance. No, I think Yharnam is a real place.

What I believe is that Yharnam is being pulled into a Nightmare realm. I think there are at least two planes of existence represented by this game, and the line between them is being blurred. Yharnam originally existed on the plane we'd call reality, where it was a normal city that had the unfortunate fate of being located over some Pthumerian ruins. The discovery of the blood, followed by studies at Byrgenwerth, followed by Laurence and his associates beckoning the Moon Presence, followed by the ritual of Mensis have somehow collectively led to the influence of the Great Ones / Paleblood and the Nightmare growing over Yharnam. Micolash is called the Host of the Nightmare, so the Nightmare of Mensis may have been planted there by the Great Ones to grow out of his mind. The Nightmare Frontier seems so unlike any earthly realm that I think it is probably a pure Nightmare plane that we're able to access due to the efforts of the School of Mensis. Hunter's Dream might be a separate plane, or it may also be another Nightmare realm hosted in the mind of Gherman, as we discover that the Dream is under the influence of the Moon Presence and other Great Ones are hanging from the pillars at the end of the game. Also, after you kill Rom, the nightmare is revealed in Yharnam, and we also see red seeping into the sky of Hunter's Dream at the same time, which might be another indication that Hunter's Dream was only another Nightmare all along.

Whatever the case, I think the Great Ones or Palebloods are responsible for the Nightmare being exerted upon Yharnam.

One of the great strength of Souls lore is that it will leave this question open-ended, so we can have endless philosophical debates about this. :) Looking forward to hearing other thoughts.