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It basically cuts the loading time on the game etc...
When the Xbox says install game it does not mean you are about to install the full game onto your hard drive. When you install a game on to your Xbox it's taking some of the game files and installing them to make the game run smoother and possibly look better.
In the hardrive in the console.
The main difference is more features and storage. The Xbox 360 Pro has a 60GB hardrive and connectors for low definition or high defninition to a TV or monitor. The Xbox 360 Elite includes a 120GB hardrive, connectors for low definition or high definition to a TV or monitor, and it includes a HDMI cable
In short: no. The Xbox 360 has to install an original Xbox emulator program to run the Xbox games. It stores this emulation software on the hard drive.