The reduction in the repo rate to 6.75 percent was the fourth rate cut this year.
Industry groups were pressing for an interest rate cut to boost economic growth after the inflation rate fell to 3.6 per cent in August. But the size of Tuesday's cut was bigger than most economists had forecast.
Reserve Bank of India governor Raghuram Rajan also lowered India's growth forecast for the fiscal year ending March 2016 to 7.4 percent from 7.6 per cent.
The central bank cut the policy rate by a quarter point in each of January, February and June as falls in commodity prices reduced inflation, giving it more scope to stimulate Asia's third-largest economy.
"In India, a tentative economic recovery is underway, but is still far from robust," the bank said in its policy statement. It said that a poor monsoon had subdued rural demand.
Indian farmers are largely dependent on monsoon rains and agricultural production is often hit by deficient rainfall.
The bank said foreign demand for goods remained weak, "suggesting a more persistent drag from lower exports and cheaper imports due to global overcapacity.'
This had led to underutilization of domestic production capacity, decelerating new orders and a rising ratio of finished goods inventories to sales, it said.
Rajan said businesses now have more certainty about the level of interest rates for the time being.
"Investment is likely to respond more strongly if there is more certainty about the extent of monetary stimulus in the pipeline, even if transmission is slow. Therefore, the Reserve Bank has front-loaded policy action by a reduction in the policy rate" by half a point, Rajan said.
He urged banks to pass the benefits of the lending rate cuts to borrowers.
Former Indian finance minister Palaniappan Chidambaram welcomed the cut in interest rates and said it was overdue.
"It signals a movement toward a lower interest rate regime and it is therefore, welcome," Chidambaram told Press Trust of India.
(AP)