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This question is perhaps one of the most often asked in the past on the XP systems. Here is how to do it in Windows 7. I have a RealTek HD Audio sound card, but the settings should be similar across any Windows 7 audio system, as they all share the new Windows 7 audio sub-systems.
First, open the Sound control panel. There are 3 ways to do this: Start menu Control Panel Flyout, Control Panels Window, or Right-Click on the Speaker icon.
If you do NOT see "Stereo Mix" in your Recording tab, right-click on an empty area and make certain that both "Show Disabled Devices" and "Show Disconnected Devices" are checked. If this brings up the Stereo Mix input, be sure to Enable it by right-clicking on it and selecting "Enable".
Now, ensure that "Stereo Mix" is selected as the default device in the Recording tab. Open it and set the Levels to 100.
Also in the recording tab, make sure your microphone input's "Listen" tab has "Listen to this device" checked and is directed to the Speakers - not anything else, or it won't work correctly. Set the levels between 10 and 100. My Line-in is very noisy with a whine from the motherboard, so that is why I have it set to 10 here, and since my mic is plugged in through a mixer going to Line In, I crank up the volume at the mixer to compensate and get better signal-to-noise levels.
Now with that done, very importantly, select the Playback tab, and make certain that Speakers are selected as the default device. If you have Headphones selected, even with no headphones plugged in so it falls-back to the speakers, the media player or game audio will not get routed to the Stereo Mix. Set the level to 100 on the main output slider, but then scroll down to the bottom on a RealTek HD Audio system, and turn the "Front" sliders down to between 40-50 to avoid overloads. The Stereo Mix receives its actual signal from this slider.
While I'm in this panel, I should mention headphone monitoring. In the RealTek HD Audio Manager, which is available from the Control Panels, you have the possibility of routing the mic or line-in to the front panel headphones via the "Device Advanced Settings" link in the upper right side. Check the first one to pass through your mic. Note that the "Line In" and "Microphone" sliders in the Speaker's properties levels tab only control this pass-through volume and have no effect upon the recording levels.
While I'm in the RealTek HD Audio Manager, make certain you have your effects disabled (unless you want them) in the Speakers tab, and double check that there is no "Red X" over the mouth of the little guy in the Karaoke setting, or it will "scoop out" the mid-range audio and sound terrible. Also go through and ensure all your Default Formats are set to 16-bit 44.1 kHz Stereo, since that is what CamStudio uses.
You SHOULD do a check to monitor your levels over your headphones. This can be done by double clicking Stereo Mix to bring up its properties and check the box in it's Listen tab, sending the output to your Headphones. There will be a 1/10th second or so delay to the microphone that is very distracting, so only use this to check your mix, then turn it off and rely on the RealTek advanced settings pass-through to monitor your mic. You'll have to "fly by instruments" once recording into CamStudio, so rehearse your volume settings in advance to get them right, or enable and disable listening to the stereo mix at intervals when necessary.
You can use the Windows 7 Volume Mixer to adjust the media player volume. It gives numbers as you move the slider so you know where you are.
Remember that in order to hear your playback of your recording after you're done over your headphones, you'll have to set "Headphones" as the default. Remember to set it back to Speakers as the default to record additional takes.
Again, a synopsis of the gain-staging is:
Microphone - Level 10-75, in Listen tab, "listen to this device" checked ==> out to speakers
Speakers - main slider 100, "Front" slider 40-50, set to default Playback device
Stereo Mix - 100, set to default Recording device
Music source adjusted to be underneath the mic volume. This can be adjusted using the audio mixer sliders (right-click speaker and select mixer)
Finally, in CamStudio, be sure to have "Record from Microphone" selected and then under "Audio Options for Microphone" select "Stereo Mix" from the drop-down. That's it!
I hope this helps you immensely. Please comment on what I might have left out here.