Speaking after a regular meeting of the two governments, Merkel said: "I have the impression that the whole government in Spain, including the prime minister, is working to get unemployment down, get structural reforms working and give Spain back the strength it deserves."
"I am convinced that the Spanish government and Mariano Rajoy as prime minister will be able to solve these problems and Germany will support him with all the strength we have," added the chancellor, when asked whether the affair had undermined her confidence in his leadership.
Rajoy faced persistent questioning over the corruption scandal in Spain but reiterated that the allegations against him were "absolutely false".
The prime minister is facing calls to resign after Spain's centre-left newspaper El Pais published account ledgers purportedly showing that donations were channelled into secret payments to Rajoy and other top party officials.
Rajoy vehemently denied the allegations and vowed to carry on at the head of a "strong" government to tackle what he said was "the gravest crisis in Spanish history."
"Our policy is one of reform and we are convinced that we are trying to get Spain out of its worst-ever crisis," he said. "The whole thing is absolutely false," he added.
The scandal drove Madrid share prices down more than three percent in late afternoon trading on Monday.