Merkel promised "good and stable government" after sealing the pact more than four months after last year's general election.
According to German media, the SPD will be given some key ministries.
Merkel's CDU and the SPD have agreed to allow up to 1,000 members of refugees' families a month to enter the country, removing a key hurdle in the formation of a government.
Bernd Huetteman, secretary General of the European Movement, believes the deal was possible because the SPD has agreed to more restrictions on migration than it initially hoped for.
“There is the big question of the immigration and refugees and I think that the SPD has compromised,” making it possible for the CDU's allies in Bavaria, the Christian Social Union (CSU), to accept the deal, he comments.
The CSU faces an election this year.
SPD wins key cabinet posts
The Social Democrats have won concessions on Europe, however, Huetteman says. “The SPD will have quite a strong stand on EU affairs and that was not the case in the last grand coalition.”
In exchange for a stricter stance on immigration, the SPD may be rewarded with a series of top ministerial positions.
According to Gero Neugebauer, a political scientist with the Free University of Berlin, the Social Democrats may be rewarded with the foreign affairs and finance posts, along with some other key ministries.
And SPD leader Martin Schulz, a former chair of the European Parliament, would be the right man for the job.
“Mr Schulz had no profile in domestic, foreign and security politics," Neugebauer points out. "But he is a very experienced European politician.”
With a former core-member of the Brussels-based European leadership at foreign affairs, Germany is in a good position to “cooperate with the other nations within the EU but we have to learn that we have to look for more equal rights for the others too”, Neugebauer says.
It means that Germany should not want to play the leader and tell countries to follow the “German model” of labour reform, something that drew the ire of countries like Greece during the fierce negotiations about its bailout programme.
Brexit a blessing
At the same time, Europe needs to be put back on track after Brexit raised questions in many countries about the sustainability of the EU bloc.
But Brexit may have been a blessing in disguise for the German policymakers now trying to form the coalition.
“Brexit is exactly the reason why we experience a turning point in German politics and European affairs,” says Huettemann.
“Our trade unions, industrial chambers of commerce, civil society organisations all say the same, ‘Brexit gave a boost of sticking together as the EU 27'. So that is the main reason why the new German government might have a new perspective."
Before Brexit, London and Paris were the main focus of the German government. Now it is Brussels and Paris.
Merkel's hope of forming a new government now lies with some 460,000 rank-and-file of Social Democrats, who will vote on whether to approve the hard-fought coalition deal.