After arriving in Grass Valley, you must venture into the Underground Castle to free the souls there.
Clear the Lairs
Near the entrance of the Underground Castle, there is a lair of Cherry Heads to the right. Only one comes out at a time. They aren't very smart, and depending on where you stand, the Cherry Head might simply stop moving and just stand there nearby while you whack it with your sword. Kill all of the Cherry Heads and step on the glowing green spot. This opens the log wall to the right. Go through.
There is a Cherry Head lair just to the right of the log wall. After you kill all of the Cherry Heads and step on the green spot, you release the soul of an old woman. Her large house gets reconstructed along with her.
You can't go any farther east right now, so instead go north up the narrow bridge. There are Pineapple Plants coming out of this lair. More will come out over time even if you haven't killed the others. Unlike the Cherry Heads, the Pineapple Plants just wander around randomly. After you kill all of the Pineapple Plants and open the lair, a treasure chest appears. It contains a Medical Herb. Be sure to select it in your inventory. If you select it, then it will refill your HP if your life meter reaches 0. Also, even if your Medical Herb gets used up, if you leave your cursor in the spot where the Medical Herb was, then you will be healed up the next time you find a Medical Herb.
To the left, there are some Water Slimes. If you go near them, they turn into round blobs and come after you. These are not connected to a monster lair, so you won't free any souls by killing them, but you will get some experience. Also, they will reappear if you come back to this area.
To the left, there is a Cherry Head lair. There is also a torch, called a Gepper, that spits out fireballs occasionally. The Gepper is not attached to a monster lair. You may wish to kill the Gepper to stop it from spitting fireballs at you. When you kill the Cherry Heads and open the lair, some stairs appear to the right, and the blue crystal speaks to you.
Go up the stairs and talk to the blue crystal. The Crystal Fairy gives you some experience and offers to transport you back to Grass Valley. You can do that if you want to heal up or talk to the old woman whom you rescued.
Back in the Underground Castle, go north from the blue crystal. There is a Cherry Head lair here, as well as some Water Slimes. Only one Cherry Head comes out of the lair at a time. After you kill all of the Cherry Heads, open the lair to reveal a bridge to the north. Go north, then east.
Here you find a Cherry Head lair on a wooden structure. Kill all of these Cherry Heads and open the lair to free the Tool Shop Owner.
Go south and you find three Gepper torches. Kill them and then open the chest, which contains 12 GEMs.
Go north to find a lair with Pineapple Plants. Kill them and open the lair to release a tulip outside of the old woman's house. It mentions that there is an elevator in the Underground Castle that won't work until you restore the water mill.
Go east across the conveyor belt. There is a monster lair that releases gold monsters with blue wings that are called Bondguards. They walk toward you like Cherry Heads, but they can stop, jump back, and shoot a white energy ball at you. The energy ball goes straight ahead, so if a Bondguard shoots an energy ball at you, step to the side to avoid it. You can prevent the Bondguards from attacking you if you stand one tile left and one tile north from the lair of the Bondguards. Kill the Bondguards and open the lair to release the bridge guard.
Go south across the bridge to find a Gepper torch, and a monster lair that releases Zip Flies. They move in a straight line toward you. They stop after moving a certain distance, then after a delay they move toward you again. Just avoid being in a straight line with them (including diagonally). When you clear the lair, a chest appears. It contains the Dream Rod. You can't use it yet, but you'll use it soon.
Go north and cross the bridge, then go east and walk south along the conveyor belt. A bunch of Cherry Heads have come out of the lair. Kill them and open the lair. This opens the room to the south that contains a bunch of Pineapple Plants. Kill those and open the lair to release some ivy in Grass Valley.
Now go west and south. Go to the bottom of the conveyor belt and kill the Bondguards coming out of the lair. After they are gone, step on the lair to create a conveyor belt that goes west. You can use this conveyor belt as a shortcut to the entrance of the Underground Castle. But before you leave, go south and east. There is an area with some Water Slimes and Bondguards. Kill the Bondguards to release the water mill keeper, who is unable to make the water mill turn.
You can go east and talk to the elevator (machines in this game have souls) who will tell you that it can't run until the water wheel is turning. So now you should leave the Underground Castle and visit the people you released. Go back the way you came and walk west along the conveyor belt. Continue west to exit the Underground Castle and go back to Grass Valley.