1. Open the image you would like to make dreamy. This effect works best with photographs.
2. Right click on the layer with your image, and select Duplicate Layer. Call the layer dream. Next we are going to blur this layer : filter > blur > gaussian blur. Now depending on the size of the image and the type of effect you want, you need to blur the image enough to make it only colours, no defined shapes. Select an appropriate radius and click ok.
3. Left click on the dream layer in the layers pallette. We are now going to change the blend mode of this layer. This basically defines how the layer will interact with layers below it. There are two ways to do this : Either on the drop down list (on the layer pallette) that says "normal", select "Screen". Or right click on the dream layer and select Blending options, then in the window that loads change the blend mode to Screen.
Finished. A good photo effect that varies alot depending on the type of image and the amount the image is blurred.