Well, there are different motives for different lies. (Not a lot are acceptable, but some are more troublesome than others, imo!)
Some people lie to look better (about their age, income, accomplishments, credentials, etc.).
Some people lie because they are truly misinformed and never take the time to educate themselves (like the email rumors a relative sends me all the time!)
Some people lie because they don't want to deal with repercussions from stating the truth.
Some people lie for the thrill of it, I suppose. (I have known people that lie about the most inconsequential things--like whether they were at the store yesterday, etc.)
And, yes, some people lie so much that it becomes their "reality" and they start to believe their own lies.
It doesn't last though, because chickens WILL come home to roost, and lies have a way of being revealed, in the end. It might take a day, a week, a year or a century, but generally, lies are revealed, I think.
How to deal with your relative? If the lies weren't directly affecting me or my family, I would probably ignore them. If they WERE directly affecting me, I have no problem calling out a liar.
Now if it's something like the way the remember past events in family life--it might be a matter of perspective. It doesn't have to change YOUR perspective, in the end.
Two expressions that apply:
Honesty is the best policy.
Oh what tangled webs we weave, when first we practice to deceive.