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Neither. It uses some kind of PSX emulator to emulate system calls, graphics etc., but it runs native x86 code. Sort of like compiling Windows app to Linux with Winelib.
AO and AE use MIDI for all music, but it doesn't use the crappy gm.dls that comes with Windows but custom soundfonts created for the game (They're a part of sounds.dat). MIDI is, in fact, a very good format as long as you use good soundfonts.
Also, can someone explain what's wrong with the PC port of AO/AE? I find it pretty accurate and well made...
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Its buggier than the PSX version being quite crash prone, many animated elements don't actually line up with the CAMs, the colours are messed up on many things, the controls are sloppy, some sprites have unnecessary modifications from the PSX version, lots of sounds do not translate well, sounding awful (the Mud escape noise for instance, and the Secret Sound), and many sprites don't display properly (especially in AE)
EDIT: One thing that is good in the PC version, or should be, is the CAMs are less compressed. However, the compression they use is HIDEOUS, having stripes to blend colours. It looks like some kind of GIF image.