Xbox360 has 512 MB of RAM. There's your answer right there. They had to work with what was available at the time that would allow them to keep the price point feasible. They actually wanted to launch it with just 256 MB, but the team that made Gears of War basically told them it had to have 512 for them to get good graphics out of it.
If they could come up with some sort of way to make the consoles upgradeable, then you would see games advance in graphic capability more over time. Maybe a modular video card that could be replaced, ability to upgrade RAM, etc.
Oh wait, they already make that, it's called a PC!
