In a shaky and halting voice, John Paul proclaimed Mother Teresa blessed, a major step on the path to sainthood.
Police and Vatican security officials estimated the crowd at 300,000, one of the Vatican's largest ever.
After a night of furious rain, the sun was shining for the ceremony. John Paul, wheeled in an upholstered chair across the front steps of St Peter's Basilica towards an altar, seemed pleased by the jubilant crowd.
"Brothers and sisters, even in our days, God inspires new models of sainthood," John Paul told the crowd.
"Some impose themselves for their radicalness, like that offered by Mother Teresa of Calcutta, whom today we add to the ranks of the blessed. In her, we perceive the urgency to put oneself in a state of service, especially for the poorest and most forgotten.
Nuns from her order wiped away tears and the crowd clapped when he pronounced her blessed and a poster of her smiling, wrinkled face was unveiled on the facade of the basilica. A procession of Indian women and girls preceded a couple carrying a piece of cotton soaked in Mother Teresa's blood toward the Pope.
Beatification opens the way for public veneration, and the relic of her blood will go on display in a Rome basilica for a few days.
After stumbling through several prayers, the Pope let aides read all of his homily. In it, John Paul said he was personally grateful to a brave woman, whom he has always felt at his side.
Among the crowd were hundreds of nuns from the Missionaries of Charity, the order established by Mother Teresa in 1949 to tend to the destitute.
Mother Teresa, an ethnic Albanian, was born in what is now Skopje, Macedonia, but spent most of her life working in India. She established convents and homes for the needy around the world.
The pontiff broke with the Church practice of waiting five years after a candidate's death before starting the often decades-long process of beatification, the last formal step on the way to sainthood.
Last year, the Pope approved the required miracle for her beatification the recovery of an Indian woman who was being treated for what doctors said was an incurable abdominal tumour.
A second miracle must be verified, after beatification, for elevation to sainthood.