The 28-page deal reached in a marathon negotiating session that lasted more than 24 hours at the end of almost a week of talks was enough for leaders of Merkel's two-party Union bloc and the Social Democrats to recommend moving on to formal coalition negotiations.
The Christian Democrat Union of Chancellor, Angela Merkel (CDU), and social Democracy of Martin Schulz (SPD), have managed to close a framework agreement to form a new grand coalition and end political crisis that Germany maintains with a government in office For 111 days.
"I think we have achieved outstanding results", Mr Schulz told reporters.
Sources said both parties had also agreed that the share of renewable energy in Germany's electricity consumption should rise to 65 percent by 2030 from roughly a third previous year.
Meanwhile, Mrs Merkel said: "The world is not waiting for us, we need a fresh start in Europe".
GettyCoalition agreement CSU leader Horst Seehofer Angela Merkel and Martin Schulz announce their progr
As the negotiations got underway, Merkel acknowledged there was a lot of work ahead, but said she was "optimistic" the parties could reach an agreement.
European Commission president Jean-Claude Juncker said the German deal was "significant" and "positive" for the EU's future.
The SPD had dreams of becoming the largest party in Germany after the last round of elections, but performed poorly as voters were critical of the center-left party's coalition with Merkel's center-right alliance.
Some fear further association with Merkel's chancellorship could erode the influence of the SPD which suffered the worst result in September's election since the modern Federal Republic was founded in 1949.
A survey published by Focus magazine found that only 30 percent of Germans favour a return of the grand coalition, while 34 percent prefer new elections.
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Going into the final round of "exploratory talks" between the parties, Merkel appeared upbeat but admitted that there were still "major obstacles" to overcome.
"The negotiations are not just about a coalition, but also their careers. It would be the end for all three if this coalition does not come about", he told public broadcaster ZDF.
Faced with the prospect of prolonging the political uncertainty of the past three months, Schulz relented on that pledge - at least for the sake of preliminary talks - but that does little to erase the growing policy differences between the two sides.
Beyond fiscal and spending issues, the parties are struggling to fend off the encroaching far right, which has seized on anger over the influx of refugees and netted a record showing at the polls in September.
On migration, an issue that is key for Seehofer's CSU, the agreement states that the number of new asylum-seekers shouldn't exceed a range of 180,000-220,000 annually.
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SPD leaders, who need to convince their party members in a vote on January 21 on whether to proceed, are playing hardball.
The SPD's youth wing chief Kevin Kuehnert has said he would embark on a national tour to press his case against a new grand coalition, known as "GroKo" in German political shorthand. Since then, the fate of a possible deal remained very much in doubt, with the principal points of contention centering on immigration policy, climate regulations and the tax code.
Some political observers expect a now weakened Merkel to leave early and allow a successor to settle into the chancellorship ahead of 2021 elections.
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