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Is this AVI you're using for your menu a DV-AVI? In other words, is it video captured over FireWire from a miniDV camcorder?
AVIs using other codecs can cause the problems you're describing.
The 15 second DVD menu background AVI was created in Premiere Elements in a separate project. I created some Titles with Motion paths, layered them and then added some music.
I then used File->Export->Movie... to save it as a Microsoft DV AVI which I then imported into the main movie project.
I then selected Create DVD and dragged the movie into the Menu Background place.
The project seems to work fine. The only issue is that the generated VOB for the menu is only 6Mb and very poor quality whereas if I create a DVD from the separate project where I created the 15 second title movie the same movie clip becomes a 15Mb clip (and hence 2-3x the visual quality too).
Note that the rest of the movie is fine. It's just the menu background that appears to have been badly compressed.
Sorry, Chris. I'm not sure what the problem is then.
Assuming you're judging your video quality by the final output, on a TV, and not by the preview you see in the DVD menu workspace, I don't know what can be done to improve it.