I would be inclined, just for safeteys sake, to act on both your suggestions.
Its a great idea to teach the grand kiddies, ragardless of your dogs behaviour, the right ways to approach any animals, particuarly dogs, it is a very valuable lesson for them to learn.
I would also teach your dog that it is not acceptable behaviour, whilst from the dogs perspective you can understand the reaction,(well i can anway

) for the safety of humans (particuarly the little ones) your pup should be desensitized, and taught to cop it on the chin (for lack of better words)and deal with it with some manners.