Angela Merkel, leader of the Christian Democratic Union, will become Germany's new chancellor and head of a grand coalition, breaking the political stalemate that followed the inconclusive September 18 election.
Monday’s agreement on her appointment came after three weeks of negotiations between the CDU and the Social Democratic Party, its main rival and future partner.
The parties will start formal negotiations on a joint government programme next week.
The agreement brings to an end the political career of Gerhard Schröder who said he would withdraw from front-line politics after seven years in the chancellery.
Ms Merkel, who will be elected by parliament's lower house next month, will be the first woman to head a German government and the first chancellor from the country's former communist east.
Equity markets reacted positively, with the DAX 30 index of German blue-chip stocks climbing 15 points to 5,022.79. “A big part of the mess left by the election has now been cleared,” said Bernd Meyer, equity strategist at Deutsche Bank.
Economists, however, cast doubt over the ability of a grand coalition the second in Germany's post-war history and the first since 1966 to adopt radical labour market, tax and social security reforms.
“I do not think this government will tackle the biting problems of labour market inflexibility or high non-wage labour costs,” said Andreas Rees, an economist at HVB in Munich.
Under the agreement the SPD will hold eight portfolios the foreign, finance, justice, development, labour and social security, health, transport and environment ministries.
Alongside the chancellor and her chief of staff, the CDU and its Bavarian arm, the Christian Social Union, will hold the economics and innovation, interior, defence, family, education and research and consumer and agriculture ministries.
The appointment of Edmund Stoiber, chairman of the CSU, as future economics minister, was the only nomination to be confirmed officially yesterday.
While the deal largely eschewed policy decisions, Ms Merkel yielded to pressure from the SPD to scrap two planks of her manifesto: a proposal to decentralise wage bargaining, which would have weakened the trade unions, and the proposed lifting of a tax exemption for Sunday and late-night workers.
“There is no alternative to the reform course,” she said, while warning that much “hard work” lay ahead in the coalition negotiations.
Franz Müntefering, the SPD chairman and his party's chief negotiator, described yesterday's deal as “a building block” for a grand coalition.
While the SPD and CDU agree on the need for fiscal consolidation, an overhaul of Germany's unwieldy federal institutions and tax reform, they remain far apart on labour market and welfare reform.
Ms Merkel's rise to the chancellery reflects her meteoric political career. A doctor in physical chemistry at the east-German Academy of Sciences when the Berlin wall fell in 1989, she was sitting in parliament a year later and had become CDU chairman by 2000.
Additional reporting by Gerrit Wiesmann in Frankfurt