My two cents' worth (and it may be only worth one): Ask to be kept posted to be sure that MIL is taking her medications!
Maybe you're doing the right thing to walk out of the room. You could say, "No, the baby is staying with me right now" (pleasantly). Perhaps your leaving gives her a chance to be distracted by something else.
Let your close friends know privately that MIL is ill and behaves strangely but is not dangerous (well, they might wonder). You could even indeed recommend that they screen their calls - sounds like a good idea to me. If they ask, you could coach them on other ways they can manage her when they're with her.
I think I know what your FIL means when he says, "Ignore her," because I'm related to a person whose family says this about lots of relatives. They may be intending to say, "Let it all roll off your back," but I've never really seen that be successful. I'd think it better for all of you to plan together how to manage MIL when there are family functions. I know that if I were a friend of yours, I'd want to be informed, so that I could be able to help.
I should imagine this is much harder than managing a three-year-old, but maybe if, when you look at MIL or think about her, you imagine a three-year-old in toddler clothes saying, "Me, me, me," it might help you to keep going.
I sincerely hope the medication will help MIL and that eventually you'll be glad you didn't cut her out of your life or badmouth her.