India's cut follows those of several central banks around the world
India's central bank unexpectedly cut short-term lending rates on Monday in response to continued pressure from the global financial crisis.
The Reserve Bank of India has cut the so-called repo rate by 100 basis points to 8% to stabilise India's finances.
This is the first cut in more than four years and comes ahead of a scheduled policy review on Friday. The change will come into effect immediately.
Banks worldwide have cut interest rates in a bid to boost their economies.
The repo rate is the discount rate at which the central bank lends money to commercial banks to infuse liquidity into the market.
The stock market jumped as much as 5.6% on the news but then fell back to close up 2.5%. On Friday it fell to its lowest close since June 2006.
Despite continued problems in the worldwide market, India's commerce minister, Kamal Nath, said he was confident India could remain a strong force on the economic stage and told the BBC its growth rate was "not as yet" under threat.
"The ingredients of our fundamentals are strong," said Mr Nath.
"We have had FDI [foreign direct investment] growth of 120% compared to the previous year. The first five months have seen 130-140% growth compared to the previous year," he added.
Mr Nath also highlighted the country's strong export growth - which increased 31% last month.
Comparing India to the US, he said none of India's banks had gone bust due to the Asian country's "stricter norms".
However, Indian Prime Minister, Manmohan Singh, proved more cautious and warned that there could be difficult times ahead.
"We must be prepared for a temporary slowdown in the Indian economy," said Dr Singh.
"The precise impact is difficult to estimate at this point since the depth and duration of the global slowdown remains uncertain," he added.
Dr Singh had been under mounting pressure to speak publicly about the issues facing India's financial markets.
The stock market has lost more than half its value this year, the rupee has fallen to new lows and cash flow problems have crippled banks - leading to jitters among investors.
There had been growing pressure on the Indian Central Bank to cut rates, however it was unknown when the cut would take place and uncertainty remained about the extent of any cut.
Analysts have largely responded positively to the news.
"A 50 basis points cut was expected... Instead, a 100 basis points cut has come in unexpected today. It is a step in the right direction," said Amitabh Chakraborty, president of equities at Mumbai-based Religare Securities.
"In a knee-jerk reaction, public sector banks and broader markets may rise. It is to be seen if the foreign institutional investors that have been selling in the Indian market, use this rally to sell more," he added.
India is the latest country to see its central bank cut interest rates.
A few weeks ago six central banks cut interest rates by half a percentage point in an effort to steady the faltering global economy.
The US Federal Reserve cut rates from 2% to 1.5% and the European Central Bank (ECB) trimmed its rate from 4.25% to 3.75%.
The central banks of the UK, Canada and Sweden and Switzerland all took similar action in the co-ordinated move, cutting rates by half a percentage point. China also cut its rate, by 0.27 percentage points.