Japan's benchmark Nikkei stock index rose by nearly one per cent after news of the cut emerged, before falling again, while the yen made a small gain against the US dollar.
The Bank of Japan, in a statement explaining its decision, said the Japanese economy was in a poor state.
"Financial conditions have deteriorated sharply on the whole … Under these circumstances, economic conditions have been deteriorating and are likely to increase in severity in the immediate future," it said.
The bank said that Japanese exports, which have driven the country's economic growth in recent years, have been falling because demand from overseas has sunk.
"Given the slowdown in overseas economies and the turmoil in global financial markets, it will likely take some time for the necessary conditions for Japan's economic recovery to be satisfied," it said.
The rate cut by the bank, which is independent of the government, comes after political leaders indicated that they were in favour of a reduction in the cost of borrowing.
Lower interest rates can reduce the value of currencies by making them less lucrative.
However, a rate cut can also provide a boost to a country's currency if the rate reduction succeeds in shoring-up the wider economy.
A stronger yen against other countries' currencies can make Japanese exports less attractive to overseas markets, prolonging economic gloom for companies looking to sell goods outside Japan.