In the village, avoid the yellow lady who hangs out to the left of the fence entrance. She'll demand that you buy a postcard, and if you refuse, she will follow you around.
Prepare to Rescue Paula
There are Insane Cultists wandering around the village who will attack you if you come near. They can call other cultists into battle, so you can get a bunch of experience by allowing more and more cultists to be called into battle.
Upgrade your weapons and equipment in the Drug Store. You can also buy (or steal) eggs and bananas from the self-service shop. If you do steal, don't talk to the Unassuming Local Guy behind the tree, or he'll attack you. Stealing eggs and selling the chickens that eventually hatch is a great way to make a bunch of money.
Ignore the eastern cave entrance for now.
Get the Franklin Badge from Paula
You should go into the cave to the left of the drug store. At the other end is the cabin that you saw earlier in Peaceful Rest Valley. Go inside to find Paula. Talk to her through the bars. Your reward for finding Paula is the very important Franklin Badge. Without this badge, you can't defeat Mr. Carpainter, so be sure to keep it in your inventory. You'll need to get the key from Mr. Carpainter before you can rescue Paula.
When you leave the cabin, Pokey will be there to taunt you, and he'll sic some crows and cultists on you before running away.
Go into the Happy-Happy Headquarters
Once you are ready, go into the big house in the center of Happy-Happy Village. There are a bunch of cultists standing around, chanting their blue-blue chant. Your path seems blocked by these guys, but if you look for the ones who are moving more quickly, you can talk to them to get them to move out of your way. Unfortunately, you will have to fight some of them to get them to move.
Get the bottom-right present if you want. It's a Croissant. If you don't need it now, though, you can ignore it and get it much more easily after you defeat Carpainter. Then you can talk to the lower fast guy, then once you get past him, talk to the two fast guys who are standing one above the other. Get the Skip Sandwich along the way, and then talk to the next set of two fast guys standing one above the other. Finally you can go all the way to the left, ignoring the cultists who are walking around in a circle.
Go through the door and up the stairs to reach Mr. Carpainter. Behind him is the Evil Mani-Mani statue, which Lier X. Agerate unearthed in Onett (you would have found this out if you talked to him after dawn in Onett). The Evil Mani-Mani statue has affected Mr. Carpainter's mind, causing him to start the Happy-Happy cult and giving him psychic powers.
Talk to Mr. Carpainter and refuse to join him, and he'll shoot lightning at you. However, with the Franklin Badge that Paula gave you, the lightning will be deflected, and Mr. Carpainter will fight you. Find out how to defeat Mr. Carpainter.
Once he is defeated, Mr. Carpainter will apologize for his strange behavior (apparently your attacks knocked some sense into him). He will give you the key to the cabin with which you can free Paula. Pokey will apologize insincerely when you go back outside, then he'll run off again.
Go and get Paula from the cabin. She comes with a free Teddy Bear! If you held onto any of your old weapons or armor, equip Paula with what you can. She starts at level 1 so she's very weak and will die quickly in battle if you aren't careful. Then head back to Happy-Happy village and upgrade Paula with stuff from the drug store. Don't get the Holmes Hat for Paula; get the Ribbon instead.
You can sleep for free in the hotel now that the Happy-Happy cult has been stopped (although the hotel guy's joke about blue sheets is pretty disconcerting).
Optional: Go through the East Cave for the Your Sanctuary Location
Anyway, if you really want to, you can go into the cave to the east of Happy-Happy Village and get to the 'next' Your Sanctuary location (Lilliput Steps), but since Paula's level is so low and since that Your Sanctuary isn't required in order to continue on, I say skip it until later, when you will be much stronger and will easily be able to defeat the Mondo Mole there.
When you're ready, head back to Twoson.