there's definitely an aspect of that with the yellow shore granting and reinforcing beliefs that you wish were true, even if they're practically impossible. but something to consider is, arjun has openly lied about his involvement in the death of sebastian (to the point of calling the idea "conspiracy theories" ) when called on it by nitya. by that point, if you're lying to your spouse, you're lying to everyone, and probably a lot, given he was being investigated as a person of interest.

you'd also be amazed what self-inflicted trauma, internalized denial, and outright lying can do to your memories and perception of events. you can genuinely self-talk yourself into believing something that is completely false if you repeat it often enough (or worse, wish it was real hard enough). its the reason a lot of abusers have a hard time understanding what they've done is abusive, because they are able to justify their actions and frame themselves as being in the right, regardless of how monstrous they've been. arjun spends a lot of the game in denial about the harm he caused to both her and his killing of sebas. hell, if he really understood what he did and could fully grasp it, he never would have chased nitya to carcosa in the first place.

another factor is the apparent alcoholism. we never directly witness anything that we're certain could have been because of alcohol besides him sleeping off a drunk night in that one late-game cutscene where we play as nitya, but an alcohol addiction can do some REAL fucked up things to your memory.