Madcap Mode occurs when you beat Bobby Khan for the first time in Normal Mode. The game starts over from the beginning with all your items and levels, but the monsters are much harder.
All monsters (Except for Whackazoid) have 20 times more health, do 10 times more damage, and give 5 times more XP. This is still affected by Kid Mystic's defense. For example, in Normal Mode, the Spitter has 10 health, does 5 damage, and gives 50 XP. In Madcap Mode, the Spitter has 200 health, does 50 damage, and gives 250 XP. All monsters also give more coins.
To make up for this, the Shop now supplies: The Shield Stone, which lowers damage taken (after defense and other boosts) by 1%; The Power Stone, which increases damage done by your fireballs* by 10%; And the Spell Stone which increases damage done by your spells and the Armageddon sword by 10%. *Warning: The Power stones only affect Fireball damage, not the homing skulls shot from the Armageddon Sword. The latter are affected by Spell Stones. For this reason, you should not buy any Power Stones if you have the Armageddon Sword. Instead, buy Spell Stones for damage, and Shield Stones for defense. All Stones can be bought up to 99 times, increasing in price each time. The percentages are calculated additively, and rounded down. This means that if you have the Armageddon Sword, the Steel Hat, 10 Spell Stones and 5 Shield Stones, then you will be able to do 20 damage per fireball, meaning the Spitter will take 10 hits to kill, and do 39 damage each hit.
Note that in Madcap Mode it's very possible for an attack to instantly kill you, even at max health. This makes Shield Stones very necessary for survival, to just get the damage down enough to survive a hit. Some Fairies also decrease damage. The Blocky Fairy lowers damage by 25%, and the Toughy Fairy lowers damage by 50%. The Steelskin spell lowers damage by 87.5%