If you enter local paths to images (e.g. just an image name, or a folder plus image name), then the data tool will look for these within the source images folder you specify. So in the case above, if you selected a folder on the C: drive called 'source', it would look for those JPG files in C:\source.
You can also get the data tool to retrieve web images, if you have a full URL. In this case, the data tool will still need a 'source' folder, but will retrieve the web image, copy it to this source folder and then process it and position it in the destination folder. For example:
If you leave the image field blank, then no image will be created in the new 'Images' folder system. However, this will not delete images that are already on the site in that location.