I think I found your camcorder model here
. According to this, it is a 1 Megapixel camcorder. This is one of the lowest resolutions that you can have for this type of device. The likely reason why it is grainy, is because of this. It is also the reason why you can record to MPEG-1 and not others that have higher quality like MPEG-4.
The reason why it is it looks good on VHS, is because there is not any type of compression from the computer. It is quite confusing for me to explain, because I do not understand all of it either.
There are a few things that I do know for sure: When recording to a VHS, it is not at a high resolution, like it would be for a CD or DVD. When you go through a computer to modify or edit the video, it will use all information available, and then try to compress it as the output(MPEG-1 is an example of the compression). When you are using a 1 MP camcorder, then it does not have alot of information to work with, as opposed to a 5-6 MP camcorder, then it has to make a choice-either have a small box with the video, or have a larger box (or full screen) and stretch the same amount of information over a larger space. The artifacts that it creates is grainyness.
I hope that has heen helpful, even if it didnt really solve your problem. The best that I could do is to explain why it happened.
We are all curious like a cat. We wonder, we ask, we learn.
Please post back when a suggestion works, so that others may learn.