This setting control, what will be the initial directory, when you want to open New file or Save existing file using File Open/Save dialog. Following options are available:
Current file directory - directory of the current file will be taken, as initial directory for the dialog. If no documents currently open, last used directory will be used.
Last used directory - directory which was used by last open/save actions done with File Open/Save dialog.
Working Directory -
working directory location defined in document defaults. If not set, directory of current file will be used, if available.