The former Hertha Berlin coach has led the club from the brink of relegation to a place in the Champions League in just over 12 months and has now been rewarded with a new deal.
"Lucien Favre is exactly the right coach for Borussia and we are delighted that we will continue along the path we have been following with him," said the club's director of sport Max Eberl.
Favre has been involved in negotiations with Monchengladbach for several months and doubts had been raised whether he would commit to a new contract.
His achievements with the club have not gone unnoticed with his name being linked to several top clubs, including Marseille and Bayern Munich.
However, the 54-year-old expressed his delight at finally reaching an agreement.
"I have been holding talks for a long time with the board and the management and I am now pleased with this contract extension and the attractive challenges which lie ahead of us," he said.
Favre took charge of the Foals in February 2011 when they were rooted to the bottom of the Bundesliga.
He managed to keep them up with victory in a relegation play-off against Bochum before guiding the club to a surprise fourth-placed finish last season.
Next season, he will have to do without the likes of Marco Reus, Dante and Roman Neustadter, but Alvaro Dominquez, Granit Xhaka and Peniel Mlapa have been signed as replacements.