I would be annoyed, because children always tend to repeat the last answer if you give them a choice of two things. That, added to the laughter and repetition of the supposed 'joke' has probably left your eldest thinking she's done the right thing and entertained everyone. If I were you I'd move on from it by continuing to praise her and encourage her to be as she was before with the baby, the more gleeful you are about her being lovely to her sister, the more she'll do that to please you hopefully.
Ignore your MIL, she sounds like she's interferring. x x x
If the other EmilyB reads this, can I have my username back please?