The country's president also said the government would cut taxes and boost public spending. The stock market rose for the first time in a week after a volatile session.
The Korea Composite Stock Price Index, which rose as much as 2.9% and dropped as much as 5%, closed 0.8% higher at 946.45. It had lost one-fifth of its value last week amid a global market sell-off.
The won continued to slide against the U.S. dollar, falling 1.4% to close at 1,442.50. The South Korean currency has declined more than 35% this year against the greenback.
The Bank of Korea lowered its benchmark seven-day repurchase rate from 5% to 4.25% at a rare interim meeting. The bank also announced it would broaden purchases of bonds from South Korean banks to boost liquidity in the financial system.
The bank said in a statement that a big cut was needed "to guard securely against the possibility of a sharp contraction of real economic activity" as the global financial crisis pounds the country's financial markets and threatens to tip other major economies into recession.
Lee Sung-il, senior deputy governor and a member of the bank's rate-setting monetary policy committee, told reporters that the moves would likely trigger improved expectations for more liquidity and help stabilize market rates, which have risen despite the rate cut earlier this month.
"These types of positive expectations were, I think, reflected in the stock market," Lee said, referring to the Kospi's modest rise. Lee said that Monday's rate cut was the bank's largest ever.
Separately, South Korean President Lee Myung-bak told the National Assembly that his government would increase public spending and reduce taxes to boost the economy.
But South Korea's difficulties are not comparable to what the country suffered a decade ago during the 1997-98 financial crisis, he said, citing $240 billion of foreign currency reserves and declining global oil and raw material prices.
"What matters is rather the psychological aspect," he said. "The most dreadful foe we have to guard against is overreacting and being engulfed in fear that exceeds reality."
Lee, who held an emergency meeting Sunday of his top officials, returned home Saturday from China, where he discussed ways to deal with the global financial meltdown with Asian and European leaders.
Goldman Sachs economist Kwon Goohoon wrote in a report that the rate cut was "decisive and proactive" and is likely to be followed by at least one more cut of a quarter percentage point early next year.
Monday's cut was only the second time the bank has lowered the benchmark interest rate at an unscheduled meeting under the current policy framework.
The first time was in the aftermath of the Sept. 11, 2001, terror attacks in the United States when the bank cut its key rate by half a percentage point.
The central bank announced Friday that South Korean economic growth slowed in the third quarter to 3.9%, as construction contracted and the global slowdown hit manufacturing and exports. It was the worst performance by South Korea's economy since the second quarter of 2005, when it expanded 3.4%.
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