Yes. Water Candles increase the monster spawn rate by 33% and increase the maximum number of spawned monsters by 50% when it's placed near you, or you're actively holding it. Merely having it in your inventory doesn't do anything.
The Water Candle was broken before the 1.0.4 update, though; its effect was instead attributed to the Band of Regeneration. This is no longer the case.
Update: Sadly, this method no longer seems to work in recent versions of Terraria. Mannequins break instantly when lava makes contact with them. Statues survive the lava, but when water contacts it, obsidian is now created which displaces the statue.
Original answer: Okay, I've been poking it for a while, and have come up with a way to destroy any amount of water with just two items! This method does require you either tunnel around to get underneath the body of water you want to drain or stand in it while working, but it's still often faster than the old fill/dig method.
All you need is a mannequin (possibly other furniture as well, but something 2 blocks wide worked best in my tests) and a bucket of lava:
- Dig a 2 by 3 hole underneath — but not connecting to — the body of water.
- Place the mannequin in the hole, then drop the bucket of lava into it. Wait for the lava to settle.
- Dig a channel from the water to your lava hole and watch the water vanish!1
- Dig out one of the blocks supporting your mannequin2 and wait for the lava to settle.
- Pick your lava back up.
Sadly, you can't reverse the process to destroy large amounts of lava — the lava will happily hover above the water, never making contact, forming obsidian, or being destroyed. Worse, attempting to pick up this glitch lava will destroy your bucket!
1 The water vanishes because, when falling into lava, it should make obsidian. However, the mannequin prevents the obsidian from being formed (as they would occupy the same space) and the water is simply removed because it has no place to pool.
2 If you aren't close enough to your mannequin chamber before breaking this block, the mannequin may fall in the lava and be destroyed. Bring spares!
Best Answer
According to Terraria's official wiki page on Water Candles:
They produce light like a regular torch or candle would. If you have them on tables as props, they produce some lovely spooky lighting. However, they don't increase the spawn rate like this.
To increase the spawn rate with a water candle, hold it in your hand. It can't just be in the top row of your inventory - it must be the currently active and held item.
Keep a weapon handy so that you can swap back and forth between your water candle and weapon as necessary. You can't hold both at the same time, but you can at least run around luring enemies out with your water candle, attack them all, then return to luring enemies out.