ANSWERS: 3
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Firewall separates two networks. It allows certain things to go in and out. It can also allow certain packets from cetain hosts to goto certain places. In even simpler terms, it controls what gets into the network and where it can go and it also can control outgoing traffic. In places where there are people who are very concerned with security, place firewall between internal network and external network to make sure they don't get hit by spammers/hackers from outside.
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Firewalls are the network equivalent of a physical firewall. They prevent things from getting past them. What can enter (or exit) is defined by a set of rules. It used to be that they were only recommended for businesses, but with the current security issues of the internet, and amount of information stored on home computers or linked to business networks, it is a good idea for any user to have a software firewall set up. For those utilizing high speed internet (especially cable as your "address" rarely changes making you an easy target to find) a hardware firewall would be best.
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I wrote a short article on this topic here http://www.nucleus.com/~k_and_d/isec.html: It describes not only what a firewall does but tries to clear up the difference between a software and hardware firewall without getting too crazy. [update] My apologies. I've been slowly migrating my articles from an old web page to one of my blog sites. The new link is http://karlcompages.blogspot.com/2007/06/karls-security-tips.html
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