Ishiba, 68, announced his decision at a press conference on Sunday.
Since the former defence minister came to power less than a year ago, his coalition has lost its majorities in elections for both houses of parliament amid voter anger over rising living costs.
He had refused calls from within his Liberal Democratic Party - which has ruled Japan for almost all of the post-war era - to step down and take responsibility for the upper house loss in July.
Instead, he has focused on trying to iron out the final details of a deal with the United States on trade tariffs that have roiled Japan's critical automotive industry.
Concern over political uncertainty led to a sell-off in Japan's yen currency and its government bonds last week, with the yield on the 30-year bond hitting a record high on Wednesday.
Speculation over Ishiba's fate was stoked by the LDP's decision to schedule a vote for Monday on whether to hold an extraordinary leadership election.
While a fresh leadership race could add pain for an economy hit by US tariffs, markets are focusing more on the chance of Ishiba being replaced by an advocate of looser fiscal and monetary policy, such as Sanae Takaichi, who has criticised the Bank of Japan's interest rate hikes.
Ishiba narrowly defeated Takaichi in 2024's LDP leadership run-off.
Shinjiro Koizumi, the telegenic political scion who has gained prominence as Ishiba's farm minister tasked with trying to cap soaring prices, is another possible successor.
"Given the political pressure mounting on Ishiba after the LDP's repeated election losses, his resignation was inevitable," said Kazutaka Maeda, economist at Meiji Yasuda Research Institute.
"As for potential successors, Koizumi and Takaichi are seen as the most likely candidates.
"While Koizumi is not expected to bring major changes, Takaichi's stance on expansionary fiscal policy and her cautious approach to interest rate hikes could draw scrutiny from financial markets," Maeda said.
Since the party does not have a majority in either house, it is not guaranteed that the LDP president will become prime minister.
Whoever becomes the next leader may choose to call a snap election to seek a mandate, analysts said.
While Japan's opposition remains fractured, the far-right, anti-immigration Sanseito party made big gains in July's upper house election, bringing once-fringe ideas into the political mainstream.
Almost 55 per cent of respondents to a poll by Kyodo news agency published on Sunday said there was no need to hold an early election.
Ishiba finalised details of a trade deal with the United States last week, under which Japan pledged $US550 billion ($A840 billion) of investments in return for lower tariffs from US President Donald Trump on Japan's key autos sector.
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