FAT32 is an updated version of FAT16 that generally uses smaller cluster sizes, simply because it creates so many more of them (232 of them, to be exact). Smaller cluster sizes result in a more efficient use of a logical drive's disk space, especially on larger drives.
Because of the smaller storage box size, a FAT32 partition saves about 20 to 30 percent more space than a FAT16 partition. On any file system, the OS can't use a single storage location to store two different files. It's all or nothing. As an analogy, think about renting a self-storage space to store an old couch. Even though the couch might only take up one quarter of the space, you still have to rent the entire space. The same goes for the files stored by a file system: the file system "rents out" the entire storage box, so the larger the boxes, the greater the potential there is for 2KB's worth of file to occupy an entire 64KB storage location.
Thus, one of the most appealing benefits of FAT32 is that it can be used with today's much larger hard drive capacities. Using FAT32, you can create XP partitions up to 32GB in size, which is also the case with Windows 2000 machines.
The FAT32 file system was first introduced with the release of Windows 95 OEM Service Release 2 (OSR2), and it has been supported on all Windows versions since then. However, it is not compatible with earlier versions of Windows NT, which includes Windows NT 4.0. If your goal is to create a dual-booting system with XP and NT 4 as your operating systems, you will probably want to steer clear of FAT32. Otherwise, there is little reason not to use FAT32 over FAT16.
FAT32 is the default choice of the XP Setup program.