At that age and for a bit longer, kids vacillate between make-believe and reality quite a bit. I had a very active imagination as a kid, and my mom says I made up stories and that she sometimes had to do some explaining to neighbors who'd been on the listening end of some of my tall tales. I knew I was adopted, so the stories I made up about how I'd come to be adopted could probably rival Harry Potter's arrival in this world...
With my own kids, I had fun with their creativity. In your specific case, I would have probably followed up with questions about how the dog would have reacted to getting bumped by a mouse who'd careened down a slide and then propel the story along to a fun, wild conclusion.
My older kids, now in college, tell me that our crazy stories are some of their favorite childhood memories, and I know they helped my very analytical, sensing engineer of a son explore creativity when he certainly wouldn't explore it through writing assignments.
So my advice, really, is to embrace it and nurture it at this age.
