Mrs Merkel called on Israel to freeze its settlement construction
Iran could face new sanctions if it does not show a willingness to negotiate on its nuclear programme, the German chancellor has said.
Angela Merkel was speaking after talks with Israeli Prime Minister Benjamin Netanyahu in Berlin.
She also called on Israel to freeze its settlement construction for the sake of progress in peace talks.
In London on Wednesday, Mr Netanyahu suggested Israel was close to an agreement on settlements.
During his visit to Germany, the Israeli prime minister has also been given original blueprints of the Nazi death camp at Auschwitz.
The plans, which date from 1941-2, were found in a Berlin flat last year and include technical drawings for a gas chamber and crematorium - a symbol of the difficult history which connects Germany with the Jewish state created after the Nazi Holocaust.
US President Barack Obama has warned that harsher penalties could be imposed on Iran if it does not take up an offer of talks on trade benefits in exchange for shelving its nuclear programme.
"If there is no positive answer by September we will have to consider further measures," said Mrs Merkel.
Speaking at a press conference after their talks, Mr Netanyahu called for "crippling sanctions" against Iran to stop its disputed nuclear programme.
"It is possible to put real pressure, real economic pressure, on this regime if the major powers of the world unite," he said.
On the settlement issue, Mrs Merkel said a freeze in construction would push forward the Israeli-Palestinian peace process.
"Progress on the issue of settlements - a freeze on settlements - is an important building block and a prerequisite for a restart of the Middle East peace process," said Mrs Merkel.
After Wednesday's talks in London, the Israeli prime minister said the US and Israel were "getting closer" to a "bridging formula" on the settlement issue, according to his spokesman.
The US wants Israel to comply with Palestinian demands that it halt all building before peace talks can start.
The Palestinians have refused to resume peace negotiations unless Israel stops all settlement building.
Chancellor Merkel has shown herself a staunch supporter of Israel and received a standing ovation in parliament last year when she pledged that her country would stand by Israel's side against any threat.
But, says the BBC's Steve Rosenberg in Berlin, she is ready to criticise when she sees fit.
During his visit to Germany, Mr Netanyahu was also due to visit a villa from where senior Nazis planned the extermination of the Jews.
He is the first Israeli prime minister to visit since the site, on Lake Wannsee on the outskirts of the capital, was opened.
The meeting comes a week after Egyptian President Hosni Mubarak said Germany was involved in efforts to secure the release of the captured Israeli soldier Gilat Shalit.
Sgt Shalit is due to mark his 23rd birthday - his fourth in captivity - on Friday, amid a wave of fresh speculation in the regional media about progress towards a deal.
Hamas wants several hundred Palestinan prisoners, including the popular and potentially unifying leader Marwan Barghouti, to be released by Israel in exchange for Sgt Shalit's freedom.
Germany has helped to negotiate Israeli-Lebanese prisoner swaps in the past.