That equation is accounting for the fact that the pulley itself has inertia. Let's say you have a mass on a rope over a frictionless pulley (the bearing is frictionless, not the rope groove!) and you are holding one end of the rope. Nothing is moving, and nothing is accelerating, so it doesn't matter that the pulley has inertia. Now suppose you let go of the rope. Gravity pulling down on the mass starts to accelerate the mass. However it ALSO starts to accelerate the pulley. As long as the rope doesn't slip, the pulley speed has to match the acceleration of the bucket. The applied force is m g. If the acceleration of the mass is a, then the angular acceleration of the pulley must be α= a/r. That means that:
M g = M a + α I
=> Mg = Ma + a I / r
=> a = g / (1+ I / (M r))
Taking the pulley to be a solid disk
=> a = g / (1 + (m/(2M)) r)
So the larger the radius or the higher the mass the more the inertia of the pulley slows down the free falling mass. This is one example of how the inertia of the pulley is used. I hope that helps.