What is a terminal emulator ?

Terminal emulator is a program that mimics a dumb video terminal. It provides access to the command line and other user interfaces available on a text terminal. Or to put it in another way, terminal emulation is all software whereas the original terminal was a piece of hardware that did the work of character rendering and (in the case 0f "intelligent terminals") understanding escape sequences, carriage feeds e.t.c.

This is a throwback to the "primitive" years where the only way to access the system was through line printers or tele-printers (where we get the name tty's). Early terminals had no CPU and only used logic gates. (And as per wikipedia, one of the motivations for developing multiprocessors was to simplify the electronics in a terminal.)

With time, none of the terminals were true terminals at all (i.e. some of the hardware jobs were being done by software, for e.g. character generation) and now there is almost no market for terminals if at all.
The modern PC using Linux(or other Unix variants) and keyboard and monitor provide virtual terminals that use no hardware at all. And in a graphical environment you can run one within a graphical window. e.g. xterm, rxvt e.t.c.

Source:
http://en.wikipedia.org/wiki/Computer_terminal