Merkel had earlier informed her centre-right Christian Democrats (CDU) that she would not stand again to be the party chairman at a congress in December to make way for new leadership.
Losing ground to their non-mainstream rivals in a series of recent elections, including Local votes in Hesse and Bavaria and the national election past year has been viewed as unacceptable by many in a nation which has until recently instinctively tied itself to the centre ground.
She later told press that she was stepping down as party leader was the first step towards a leadership transition.
According to "multiple media reports", Merkel announced her intention to retire as the chief of the CDU.
After speculation by media and politicians alike around why the chancellor made the announcement, Ms. Merkel said she had chose to signal that she had heard the message voters were sending.
German Chancellor Angela Merkel attends a news conference following the Hesse state election in Berlin, Germany, October 29, 2018. Her centre-left governing partners' dismal performance left them level with the resurgent Greens in second place, while the far-right Alternative for Germany entered the last of Germany's 16 state parliaments.
She has been CDU leader since 2000.
Merkel's Christian Democratic Union (CDU) sustained heavy losses in the central state of Hesse, slumping to 28% - a 52-years-low and 10 percentage points lower than at the last state election in 2013.More news: Oscar strengthens into tropical storm; no threat to land
Merkel is now headed for a re-election bid in December within her own party, where only 13% of responding CDU voters believe that Merkel has helped the party within Heisse, and this marks the fifth time that Merkel's government has come close to collapsing in on itself from within. Her fourth-term government took office only in March but has become notorious for squabbling.
Merkel will now concentrate on smoothing over the differences in her government to keep it running until the end of the parliamentary term in 2021, which is far from guaranteed.
Sunday's voting followed a state election in Bavaria two weeks ago, in which the SPD and CSU also suffered major setbacks. Merkel's favoured successor is CDU party secretary general Annegret Kramp-Karrenbauer. Merkel's party managed an unimpressive win in Hesse, narrowly salvaging a majority for its regional governing coalition with the Greens in the state.
The Social Democrats' leader, Andrea Nahles, on Sunday demanded a "clear, binding timetable" for implementing government projects before the federal coalition faces an already-agreed upon midterm review next fall.
The shock decision signals the beginning of the end for a chancellor who put her stamp on Europe and beyond defending moderation and liberal values that have increasingly come under attack.
Her Catholic, western German background contrasts with Ms Merkel's Protestant, eastern roots.
Merkel's decision has made it even more likely that the SPD will withdraw from the coalition, which would shift the burden of responsibility for the government's failure onto the Social Democrats' shoulders.
FXTM analyst Jameel Ahmad said Merkel's announcement was not the type of news that is expected to have macro-economic implications.