German Social Democrat Olaf Scholz says he has reached an agreement with the Free Democrats and Greens to form a new coalition government that will end Angela Merkel’s grip on power.

Mr Scholz will replace Ms Merkel as Chancellor following the successful deal that aims to modernise Europe’s largest economy and accelerate its green transition.

The deal seals Germany’s first three-way federal coalition government since the 1950s – made up of Social Democrats (SPD), libertarian Free Democrats (FDP) and the ecologist Greens – and ends 16 years of Merkel-led conservative government, marking a new era for relations with Europe and the rest of the world.

According to 177-page agreement struck after two months of talks, the three parties want to accelerate public investment in green technology and digitalisation while returning to strict debt limits from 2023 onwards.

“We want to dare to make more progress,” Mr Scholz said in Berlin, flanked by the FDP and Greens leaders.

“We will massively invest in Germany to keep it at the forefront.”

He vowed to bring about “politics with high impact,” hailing plans to increase the minimum wage and more ambitious climate goals, among other things.

The alliance – named a traffic light coalition after the three parties’ respective colours – has a majority in the lower house of parliament and hopes the government will be sworn in early next month after the parties ratify the coalition pact.

It has immediate challenges, with Germany facing its worst COVID-19 surge yet and Europe grappling with the fallout from Brexit and a crisis on the EU’s border with Belarus.

Angela Merkel has served as Chancellor since 2005. Photo: Getty

Ms Merkel leaves big shoes to fill.

She has navigated Germany and Europe through multiple crises and been a champion of liberal democracy.

Her critics say she has managed rather than solved problems and leaves her successor tough decisions on many fronts.

Presiding over what could be her final cabinet meeting, Ms Merkel bade her colleagues farewell, and Mr Schulz presented the EU’s longest-serving leader with a tree to plant in her garden, according to a person at the meeting.

-with AAP