If you have already used all the drive space for existing partitions, then you will need commercial software such as 'Partition Manager' or the like to do the job. Windows XP cannot resize partitions, it can only delete them or create new ones in 'Unallocated space'.
If you do, however, have unallocated space on your hard drive, then go:
Control Panel
Performance and Maintenance
Administrative Tools
Computer Management
Disk Management
You'll see the unallocated space there and be able to create a partition in it, and then format it for use. If it's for the backup of a Windows 98 system, (via networking of course) then yes, you should create it as a FAT32 partition. Whatever software you are using to create a drive image of the Windows 98 system needs to be able to store and retrieve the image via Local Network.
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Grandad
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since Mar 2004