Phase generated carrier (PGC) technology is the core technology of multi-wavelength fiber displacement sensor (MWFDS). A square-wave phase modulation and demodulation (SWPMD) method was proposed. The corresponding optical system was established for research purposes, which precisely controlled the phase modulation of multi-wavelength beams using square-wave signals. Digital processing was applied to the collected interference signals to achieve phase demodulation, thereby reconstructing the displacement information. The simulation experiment systematically analyzed the impact of modulation signals with different frequencies and changes in the initial phase of square-wave modulation signals on the accuracy of displacement reconstruction. The root-mean-square error (RMSE) of displacement reconstruction remained stable within the range of 0.15 μm to 0.3 μm regardless of the modulation parameters. By applying the SWPMD method to reproduce complex displacement trajectories, the universality and effectiveness of the SWPMD method in improving the performance of MWFDS were demonstrated. Finally, the reproduction of square wave displacement with different step sizes was calculated and analyzed, proving that the proposed method could theoretically achieve a resolution of 0.1 nm displacement measurement.