As part of your Schengen visa application, you are asked to provide proof of accommodation. A fake booking certainly will not work, because a fake booking is not a proof of accommodation, because it is fake.
However, a hostel booking, regardless of how cheap or expensive, regardless of the cancelation policy, and regardless of where you booked it, is a proof of accommodation. It should therefore satisfy the requirements. Tens of thousands people travel every year to the Schengen and stay in hostels. It is a perfectly acceptable proof of accommodation. There is no reason that a visa should be rejected on these grounds in any reasonable interpretation of the Schengen rules.
Be warned that if you choose to make a booking at a fancier place and then cancel it after your visa is issued, you are in theory committing visa fraud. Although you are allowed to change your plans for legitimate reasons, there are unconfirmed but numerous reports that some consuls in Russia and Ukraine annul visas if hotel bookings are canceled immediately after the visa is issued. For more on this, read user ach's answer to this question: Can I change my route and hotel reservation after getting a Schengen visa?
