The quarter percentage point cut in the official policy rate to 2.5 per cent comes after South Korea's parliament earlier this week approved $15.3 billion of stimulus spending through an extra budget.
Bank of Korea Governor Kim Choong-soo said the interest rate cut was intended to "maximize the effect of the extra budget."
Other central banks are also lowering borrowing costs to spur lending and growth amid an uncertain outlook for the global economy. Europe, India and Australia reduced key interest rates this month while the Bank of Japan and the U.S. Federal Reserve are engaged in an unprecedented expansion of their domestic money supplies.
The South Korean rate cut was a surprise to financial markets. Most analysts expected the central bank to leave interest rates unchanged after Kim said in April that the economy was on track for slow recovery and the central bank's monetary policy stance was already supporting growth.
Kim expressed concerns about the Japanese yen's fall against the U.S. dollar and other currencies, which hurts South Korean exporters that compete with Japanese companies in overseas markets.
In support of Tokyo's economic revival plans, Japan's central bank is aiming to double the money supply over the next two years to end a prolonged and debilitating spell of deflation in the world's third-largest economy. The yen has dropped about 20 per cent against the dollar since late 2012.
The weaker yen is taking its biggest toll on South Korea's steel and auto industries. Japan's steel exports grew 10.7 per cent in the first quarter over a year earlier while exports of South Korean steel declined 10.6 per cent in the same period, according to the Korea International Trade Association.
In the auto industry, Toyota Motor Corp. said the yen boosted operating profit by 150 billion yen ($1.5 billion) in its business year ended March 2013. Most of that gain would have come in the January-March final quarter of the fiscal year when the yen's fall gathered pace.
Hyundai Motor, South Korea's largest automaker, reported a 15 per cent drop in earnings for the first three months of this year from over a year earlier. Hyundai blamed lower vehicle production at local factories, but said the yen's slide was a concern because Japanese automakers could aggressively lower prices of their cars to erode Hyundai's share in the low- to mid-end markets.
"So far the yen's problem is not only that its slide is wide but also that its change is too rapid. It threatens the stability in the market," Kim said. "We don't see that the yen's slide has stopped."
South Korea's economy will continue to improve at a moderate pace but the possibility of a further slide in the yen is a risk that could hurt growth, the central bank said in a statement.
South Korea's government reduced its growth forecast for the country to 2.3 per cent in March from 3.0 per cent, citing the impact of the yen on the economy. Growth in 2012 slowed to a three-year low.
Exports edged up 0.4 per cent in April from over a year earlier thanks largely to the increased shipments of electronics. But factory investments turned lower and domestic demand remained weak as companies are still reluctant to boost spending.
Kim said the bank expects the May rate cut to add 0.2 percentage point to South Korea's economic growth this year.Suggest a correction