According to what i know, mkinitrd is used to create initial ram disk images. it takes 2 arguments, first is the name of the initrd file and second is the kernel version in /lib/modules. /lib/modules actually contain many modules, but when you create an initial file system using mkinitrd, you find that the lib directory in this initrd filesystem contains only ext3.o and jbd.o modules (which are the only modules that are actually required). But how does mkinitrd know that from /lib/modules/kernel-version, these two are the only modules that are needed at boot time.

The purpose of the initrd is to have a running kernel before the search for hard drives takes place.
This is why it it loaded into ram, the ram is easy to find.

It was used primarily for difficult drives, eg scsi, raid, nfs, usb, pcmcia etc where the hardware needed to be setup before the full filesystem could be found.

If you do less /sbin/mkinitrd you can read the script that makes the initrd image..
man mkinitrd has more info too..