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"Layers" of Cache
There are in fact many layers of cache in a modern PC. This does not even include looking at caches included on some peripherals, such as hard disks. Each layer is closer to the processor and faster than the layer below it. Each layer also caches the layers below it, due to its increased speed relative to the lower levels:
What happens in general terms is this. The processor requests a piece of information. The first place it looks is in the level 1 cache, since it is the fastest. If it finds it there (called a hit on the cache), great; it uses it with no performance delay. If not, it's a miss and the level 2 cache is searched. If it finds it there (level 2 "hit"), it is able to carry on with relatively little delay. Otherwise, it must issue a request to read it from the system RAM. The system RAM may in turn either have the information available or have to get it from the still slower hard disk or CD-ROM. The mechanics of how the processor (really the chipset controlling the cache and memory) "look" for the information in these various places is discussed here.
It is important to realize just how slow some of these devices are compared to the processor. Even the fastest hard disks have an access time measuring around 10 milliseconds. If it has to wait 10 milliseconds, a 200 MHz processor will waste 2 million clock cycles! And CD-ROMs are generally at least 10 times slower. This is why using caches to avoid accesses to these slow devices is so crucial.
Caching actually goes even beyond the level of the hardware. For example, your web browser uses caching itself, in fact, two levels of caching! Since loading a web page over the Internet is very slow for most people, the browser will hold recently-accessed pages to save it having to re-access them. It checks first in its memory cache and then in its disk cache to see if it already has a copy of the page you want. Only if it does not find the page will it actually go to the Internet to retrieve it.
Next: Level 1 (Primary) Cache