With the question being asked by a toddler, it is best to be vague. I would say something like "the baby is made when mom's and daddy's love each other and want to have another baby. I would not get into the birds and the bees at that age. As the child ages, you can go into more intimate details. Also, if you are religious, you can just say that mom and dad asked God for another special child.
I hope this helps! It is important to keep the information to the level a child can understand. If you are curious on how to broach the subject, you can always talk to your pediatrician. Most will be happy to explain it to a child at their next visit.