Maybe the former, though I suppose I could still make the same argument. (So, hmm, it's more like inlining than like tail-call optimization.)

Perhaps it's most accurate to say: our dreams don't simulate enough of the world, well enough, for questions like "is such-and-such within that dream an experience of X happening or a dream that X happens?" to have answers. (Just like there might not be an answer to questions like "Was that thing you dreamed about really an old enemy of yours who had turned into a dragon, or was it a dragon pretending to be your old enemy?" or "What was on the other side of that door that kept moving away every time you turned towards it?".)

But I bet that neurologically the dreams from which you eventually pseudo-wake-up into other dreams are no different from the ones from which you wake up properly, into the real world.

Ye-ess, although "neurologically" seems to me to somehow miss the point. My experience when reading a book in which one of the characters tells a story-within-the-story is neurologically not qualitatively different from my experience when reading a book that's only one layer deep, but that doesn't stop it being a story depicted within the story.

I can see that for some purposes dreams and deliberate fiction are very different things, but for the purposes of me waking up afterwards and going "wow, that was really cool", I'm inclined to treat dreams as basically a kind of improvised fiction...

When you read a book with a story-in-a-story-in-a-story, you're keeping track of the nesting of the stories. (I hope.) When you have what's commonly called a dream within a dream, you aren't, and the nesting is only "discovered" post facto, after the allegedly nested dream is over. And, if my limited experience of such dreams is representative, the existence of the allegedly-nested dream has little impact on subsequent events in the "outer" dream, so there's not much psychologically or literarily to distinguish these supposedly nested dreams from merely sequential ones.

To a great extent we're arguing about words rather than facts here...