Almost a month after Merkel won a second term, her conservative Christian Democrats (CDU) and their new partners, the pro-business Free Democrats (FDP) have agreed the basic outlines of policy on a range of issues.
These include effectively scrapping the 2000 decision to abandon nuclear power by around 2020 by extending the life of some reactors, as well as reforms to the health care system and increased spending on education.
In foreign policy, they want to press for the Afghan government to take on more responsibilities so that Germany's 4,200 troops can come home, and to leave the door open to Turkey joining the EU.
But they have saved the thorniest issue to last: how to marry both parties' electoral promises of tax cuts with the harsh reality that Germany, Europe's largest economy, is broke.
With the global recession pushing export-dependent Germany into its worst slowdown since World War II, the government is on course to spend €50 billion ($75 billion) more than it takes in this year. It already spends tens of billions in interest payments on its debts each year, and will be forced to borrow hundreds of billions of euros more over the next few years, putting it in breach of EU deficit rules.
Once a pillar of fiscal responsibility in Europe, Germany's national debt now stands at around €1.5 trillion, or around €20,000 per citizen.
The free market-oriented FDP, led by Guido Westerwelle, promised in its election campaign €35 billion worth of tax cuts and to take the axe to government spending. But Merkel promised lighter cuts lighter tax cuts of €15 billion, and is wary of stoking protests from Germany's powerful unions.
Earlier this week it appeared as though the parties had found a way out of the impasse by proposing a special fund not part of the federal budget to cover €40 billion worth of social security spending over the next four years.
This would have given the new government a clean sheet next year and would have allowed it to circumvent a constitutional amendment imposed by Merkel earlier this year aimed at 2011 gradually clawing Germany back in the black.
But the parties were forced to go back to the drawing board, admitting on Thursday, after howls of protest from commentators slamming the idea as dishonest trickery, that it would be unconstitutional.
"Evidently the FDP and CDU/CSU have realised in time that it is better not to establish the new government on the basis of lies and deception," the conservative Frankfurter Allgemeine daily said in a Friday editorial.
Beyond Merkel remaining chancellor, it also remains unclear how the various ministries will be shared between the three parties, the FDP, the CDU and its Bavarian sister party, the CSU.
In previous coalitions like this, the head of the FDP has taken the post of foreign minister, and Westerwelle is likely to maintain the tradition.
The post of finance minister is seen as key. Once that is filled, the other jobs then fall into place. Sources said on Friday that the CDU's Wolfgang Schäuble, currently interior minister and a former close ally of ex-chancellor Helmut Kohl, would take that job.
Reports said that the CSU's popular Karl-Theodor zu Guttenberg would move from the Economy Ministry to defence, and that Thomas de Maiziere, Merkel's trusted lieutenant as her chief of staff, would become interior minister.
Talks were due to continue late into the night on Friday, and the parties aimed to present their common programme on Saturday morning.
Volker Kauder, the CDU's parliamentary group leader, said that Friday would be "a long day. But I think it will be the last day of talks."