Dill lies as a way to feel wanted and included.
Charles Baker Harris is a little boy with a big imagination. He comes to Maycomb to stay during the summer with his Aunt Rachel. If you think about it, this is a bit of a red flag. It means that there may be trouble in his home life.
There is. His father is absent. We never get the full picture. Stories about Dill’s father are almost always tall tales.
[He] said he had seen his father. Dill's father was taller than ours, he had a black beard (pointed), and was president of the L & N Railroad.
"I helped the engineer for a while," said Dill, yawning.
"In a pig's ear you did, Dill. Hush," said Jem. (Ch. 4)
It is not hard to imagine why Dill would make up stories about his father. He feels an emptiness there. Notice that he compares his father to Atticus. He sees how Scout and Jem are with their father, and has a longing for the same kind of relationship.
He wants Scout and Jem to admire him. Most of Dill’s stories revolve around this kind of embellishment.
Dill Harris could tell the biggest ones I ever heard. Among other things, he had been up in a mail plane seventeen times, he had been to Nova Scotia, he had seen an elephant, and his granddaddy was Brigadier General Joe Wheeler and left him his sword.
"You all hush," said Jem. (Ch. 5)
Jem’s reaction to both stories is essentially the same. He neither accepts nor disparages. He pretty much deflects the story and moves on. Jem is generally kind to Dill, and accepting of his whoppers. Scout is more frustrated by them. Scout says that “Dill had been studied and found acceptable” (Ch. 1) when they first meet him. He is a boy, and even though he is younger than Jem, that makes him a hot commodity. In some cases, this makes Scout feel left out though.
When Scout comes into her room one night to find him hiding under her bed, Dill comes up with his biggest story of all. He explains that his mother remarried, and he had to run away from his wicked stepfather.
Dill recited this narrative: having been bound in chains and left to die in the basement ... by his new father, who disliked him, and secretly kept alive on raw field peas by a passing farmer who heard his cries for help ..., Dill worked himself free by pulling the chains from the wall. (Ch. 14)
The incident is so serious that Dill does not even keep up the ruse for long. He finally admits that "they just wasn't interested in me" (Ch. 14). That is it in a nutshell for Dill. All he wants is to be loved, and needed, and noticed. The reason he tells his tales is so people will pay attention to him. He ran away, back to Maycomb, because in Maycomb he feels loved.
You can tell that Lee really cares about the character of Dill. There is no malice behind his lies. His stories are designed to get people to listen to him longer, so that they pay attention to him. Dill is a good storyteller. Maybe he will grow up to be a writer!