Chancellor Angela Merkel has announced her efforts to form a three-way coalition government have failed, thrusting Germany into a political crisis and pushing Europe's largest economy closer to a possible new election.

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The pro-business Free Democrats (FDP) unexpectedly pulled out of more than four weeks of negotiations with Ms Merkel's conservative bloc and the ecologist Greens, citing irreconcilable differences.

The euro hit a two-month low against the yen soon after FDP leader Christian Lindner said on Sunday that his party was withdrawing from the talks as the three would-be partners could not find common ground on key issues.

A tired looking Ms Merkel said she would stay on as acting chancellor and would consult with President Frank-Walter Steinmeier on how to move forward, adding that a deal had been within reach.

"It is a day of deep reflection on how to go forward in Germany," Ms Merkel told reporters.

"As chancellor, I will do everything to ensure that this country is well managed in the difficult weeks to come."

It was a sobering moment in the career of a woman who during 12 years in power became a symbol of stability, leading the euro zone during its debt crisis and building compromise within the European Union on a deal with Turkey to stem migrant arrivals.

Ms Merkel was weakened after a September election as voters angry with her decision in 2015 to open Germany's borders to more than a million asylum seekers punished her conservatives by voting for the Alternative for Germany (AfD) far-right party.

The break down of the talks leaves Germany with two unprecedented options in the post-World War II era — Merkel forms a minority government, or the president calls a new election if no government is formed.

The centre-left Social Democrats, Ms Merkel's current coalition partners who were the second-biggest party in the election, have ruled out a repeat of an alliance with her conservatives, who won the vote but were left with fewer seats.

There is little appetite for a new election. The main parties fear the AfD would win more than the almost 13 per cent of votes it secured to enter parliament for the first time as the third-biggest party.

'Difficult for economy'

Failure to form a government in Europe's largest economy could have implications for everything from euro zone reforms championed by French President Emmanuel Macron to the shape of relations with Britain after it leaves the EU.

The next government was also expected to increase spending, raising hopes of more fiscal stimulus for an economy that has been relying on consumption and state spending for growth.

While campaigning for a fourth term, Ms Merkel cited the strong performance of an economy that has been growing since 2010 and a record low unemployment rate as reasons for voters to back her conservatives.

Economists have accused her of complacency on the economy, saying she should overhaul the tax system to make it more growth-friendly and boost investment on digital infrastructure — demands also made by the FDP.

The Chambers of Industry and Commerce said a prolonged period of uncertainty would be bad for the economy.

The break down of the talks came as a surprise, especially as it was announced by the resurgent FDP, Ms Merkel's preferred coalition partners who had dropped out of parliament four years ago and had ruled with her conservatives during 2009-2013.

Immigration was the main sticking point in the negotiations.

Ms Merkel's Christian Democrats and their Christian Social Union Bavarian allies had demanded a yearly cap on the number of asylum seekers that Germany accepts each year, a measure rejected by the Greens.

Reuters